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Payback

The amount of time it takes for an investment to recover or pay back the initial cost of the investment (capital outlay). It is calculated by dividing the initial capital cost of the investment by the annual net cash flow ie revenue less expenses or net savings made, (it does not include the initial investment cost). Example: Initial Investment in a project is £100,000. Cash flows at the end of each year are as follows: Y1 £10,000, Y2 £15,000, Y3 £25,000, Y4 £40,000, Y5 £60,000. Total cash inflow is £150,000. After year 4 a total of £90,000 has been paid back (£10 + 15 + 25 + 40). Another £10,000 is, therefore, still required from year 5 to cover the original investment. To calculate the exact month in which payback occurs, the amount outstanding, ie £10,000 is divided into the total cash flow expected for year 5 (ie £10,000 / £60,000). This figure is then multiplied by 12, as there are 12 months in a year (or 365 if the number of days were required). Payback is, therefore, 4 years and 2 months (rounded up). NB This calculation obviously assumes cash flows are constant throughout the year. When using this method to choose between projects, all other things remaining equal, the project with the shortest payback will be chosen, the implication being that the project is less of a risk.

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