#2 Payback Period – Investment Decision – Financial Management ~ B.COM / BBA / CMA #Finance

hi everyone this is the second CashNews.co of investment decision chapter and in the first CashNews.co of this chapter we have discussed about this chapter we have seen the process of Capital Budgeting we have just gone through the techniques of

Capital Budgeting write the eValuation techniques how do we evaluate the project rate we have seen that now in this CashNews.co what are we going to do is in this CashNews.co we are going to start off with the first technique of

Capital Budgeting that is payback period right we are starting off with the payback period technique so you need to understand what is this technique see this technique is about how soon can we get our cash back how soon can we get our initial investment back for

example if you are investing in a project right 100 rupees let’s say just one example hundred rupees and let’s say the annual cash inflow the money which we are going to get inflow of cash will be equal okay 20 rupees 20 rupees 20 rupees individually equal for say let’s say for

seven years just for an example right for seven years so how long would it take to recover our initial investment now you can easily say it’s very simple 20 20 20 20 25 years right if you get five 20s you will make hundred right so we will recover our cash back isn’t it we will get our

initial investment back that is what this technique is about how soon can we get our cash back that’s it it’s very simple that’s it nothing it took five years to recover our initial investment simple as that okay it took how many just five years to recover initial investment but

five years is very long time so it’s not a good project okay if it exceeds three four years it’s not a good project but it depends upon the management fine so that is what this technique is all about how soon can we get our cash back okay there is a formula for it but it’s very

simple see the formula is initial investment fine initial investment divided by annual cash inflow that’s it initial investment divided by annual cash floo hundred divided by 20 that is five years right isn’t it zero zero cut to ones a two to five to ten that’s at five years so it

will take five years to recover that hundred rupees so that is it how soon can we get our cash back okay payback period so now we’ll see the problems and there’s one more thing cumulative Cash Flows when the cash inflows are not equal here the cash inflows are equal

right but what is they are not equal right that we will see will solve that problem in this CashNews.co only okay so let’s all the problems okay them now here the problem see here the first problem initial investment 25 lakh annual cash inflow five lakh for eight years now the ears here

don’t matter okay we just have the initial investment annual cash inflow we call the formula that’s it right what was the formula initial investment divided by cash inflow annual cash inflow right you can only use this formula when the Cash Flows are equal right here

they have said it’s equal five lakh for eight years for every year will be five like five like five like five line right so just put on the formula that’s it right calculate the payback period how will you do it it’s very simple Co initial investment divided by annual cash inflow

twenty five lag divided by five lakh right see here twenty five lakh yeah divided by five flag it is equal to five so it will take five years it will take five years to recover the initial investment that’s it simple yeah now let’s see one more problem now here’s the second

problem CEO suggests the management using payback period see here there are two projects over here the machine a and the machine B now the company is in need of a machine but it has two options machine a and machine B so which will you suggest to the management that is what this question is asking

and you have to do that using the payback period method okay the simple technique of Capital Budgeting okay this is what is Capital Budgeting you are analyzing the projects and suggesting the management right you’re a

financial analyst right so machine a initial investment is fifteen cash inflow is five lakh right you have to invest 15 lakh and you will get cash inflow five flag okay and then here machine B initial investment is 20 lakh and cash employees five like 50 just put on the formula what is the formula

initial investment divided by annual cash inflow right so 15 lag divided by 5 lakh 15 lakh you are by 5 lag that is what clears let’s say this is 15 lakh 15 lakh divided by 5 that is equal to 3 for 3 years right so within 3 years the initial investment will be recovered right in the project a

in the machine a now for the machine B initial investment is 20 and the cash inflow is 5 lakh fifty thousand right so formula 20 lakh divided by five fifty initial investment divided by annual cash inflow that gives you let’s calculate 20 divided by 5 point 5 that is equal to 3.6 3.6 right so

it will take three point six years right it’s very simple the payback period is nothing it’s very very basic yeah it’s simple right yes so which machine will you suggest of course the machine with the shorter payback period you have the smaller payback period that when you will

say just right so go for machine a by machine a right because this machine if you purchase this machine then within 3 years you will recover the cost of that machine the initial investment that’s the logic it’s very simple how soon can you get your cash back that’s all this method

talks about right how soon can you get your initial investment back that’s it now let’s see cumulative Cash Flows when the when the inflows the cash inflows are not equal then what you have to do right let’s see that now here is the third problem of payback period

method see here an industry is considering investment in a project which caused rupees six lag right the initial investment is how much the initial investment is six left six hundred thousand fine and then they have given us the cash inflows now as I said when the cash inflows are not equal as they

are here CEO one lie twenty thousand in the first year one like 40 in the second year one like eighty two lag to like 50 so they are not equal are they no they are not they are not equal right so when they are not equal you cannot use the formula what formula you remember the formula right initial

investment divided by the annual cash inflow you cannot make use of that formula right so what do we do we just make these three columns okay we’ll come to that so here they have said calculate payback period so how do we calculate the payback period when the cash inflows are not equal so

when they are not equal you have to make use of cumulative Cash Flow okay this way I will show you it’s very simple first take the years column 0 1 2 3 4 5 right 5 Cash Flows are there cash inflow right 1 2 3 4 5 so 5 years fine now what is 0 your your 0 your

0 is nothing but the first day of the first year that is when we invested the 600,000 the 6 line right so that is why I have put this in negative this is the outflow outflow of cash right we invested the money right so this is the outflow so I have put this in the negative okay and then the

following are the inflows so they are positive ok 1 like 20 in the first year at the end of the first year 1 like 40 at the end of the second year 1 like 80 at the end of the third year to lag at the end of the 4 there like that okay these are the cash inflows fine so you just have to do the

cumulative Cash Flow and this is very simple I will show you how see here properly okay so first what happened first we invested the 6 lakh right we invest in the 6 legs so put it exactly like that again the negative now we need 6 lakh to cover the initial investment that is the

logic ok so slowly one by one we are going to recover okay see here first take the calculator right take the calculator right so don’t put the suicide – 6 lakh right – 6 lakh now you are going to plus one by one in the first year what happened you got 120 so plus 120 right so when

you add 120 2-6 lag what will happen you will get minus 4 8 it is – okay in the top if you can see it see it’s – right it’s minus so minus 4 80 now still we have to recover for 80,000 right 480,000 that is for like 80,000 you have to recover that to cover the initial

investment and then in the second year what do we get in the second year we got one lakh forty thousand so add one lakh forty thousand simple sorry one lakh forty thousand yeah so three like forty yeah now we need – three forty so we are need of we are in need of three forty thousand fine

three like forty thousand then in the third year we got one like eighty so add one like eighty yeah so we are in need of 160 still negative it is still in negative right we have got the third year Cash Flow cash inflow and still the amount is in negative – 116 so now in the

next year what do we get – leg so add that to lakh we are getting 2 lakh so now it has become positive see no – there right no – there it is positive positive 40000 so that means between the year 3 & 4 what has happened between the year 3 & 4 the initial investment of 6

lakh has been recovered here here it has been recovered okay so now how do we know exactly when it was recovered we just know that it was at the end of the third year the third year was over right and it was in the fourth year that the initial investment was recovered right so how do we know it

exactly see it’s very simple but you know right it has happened after the year 3 so first you take 3 year okay 3 year plus something some decimal is there it has taken some months and we have to know that exactly ok so what do we do is this simple formula simple logic formula ok see here in

the third year when we received one like 80,000 right in the third year when we received one like 80,000 we are still in need of 160 right when we got 180 in the year 3 right we were still in the need of 1 like 50000 right before the positive we were in need of thirty thousand so that is what we

are going to do one less 60,000 we were in need of before the positive yeah how much we we are going to receive in the following year in the next year that was too late right in the year three we were suppose we were in negative of 160 right we were in need of 160 we were going to receive 2 lakh

just take the fraction of that simple 160 we were in need off we were going to receive in the next year 2 lakh right so the fraction is 0.8 the decimal is 0.8 right so 3 year it took 3 year plus that decimal plus those months ok 3 years plus 0.8 1 lakh 60 divided by 2 lakh that is 0.8 so 3 years

plus 0.8 that is 3 point 8 years ok so this is the payback period this is how you do it the only tricky thing is here only here only the students get confused but I just call in easy solution to that see you when you get the positive just take the the previous figure right the previous figure just

take the previous figure divide that by the the positive the the figure that is adjacent that is side by to the positive finger okay 1 16 divided by 2 lengths that’s it it’s very simple don’t confuse it it’s very simple when you get the positive figure the previous figure

divided by the adjacent the side 1 okay to like that’s it 160 divided by 2 like you will get the decimal figure okay so when you get the positive that means in that ear there has been recovery of the initial investment ok this is how you do it this is the cumulative Cash Flow

it’s very simple we start off with the negative this is what we need and slowly we add on first we take the negative ok first while taking first you have to press -6 like okay it’s a negative now then slowly go on adding year by year the inflows of cash and then when you get the

positive then take the the prefigure right the previous figure and divided by the the side figure okay okay then intro the next inflow then you will get the decimal and then easily even calculate the payback period okay simple right so this is how you do it okay you got the payback period yeah

it’s very simple fine okay then in the next CashNews.co what are we going to do we are going to see the Accounting rate of return method or the Roky method okay all right