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-$50,000

$30,000

$20,000

$10,000

$5,000

payback period is two years. If we require a payback of, say, three years or less, then this investment is acceptable. This illustrates the payback period rule:

Based on the payback rule, an investment is acceptable if its calculated payback period is less than some prespecified number of years.

payback period

The amount of time required for an investment to generate cash flows sufficient to recover its initial cost.

In our example, the payback works out to be exactly two years. This won't usually happen, of course. When the numbers don't work out exactly, it is customary to work with fractional years. For example, suppose the initial investment is $60,000, and the cash flows are $20,000 in the first year and $90,000 in the second. The cash flows over the first two years are $110,000, so the project obviously pays back sometime in the second year. After the first year, the project has paid back $20,000, leaving $40,000 to be recovered. To figure out the fractional year, note that this $40,000 is $40,000/90,000 = 4/9 of the second year's cash flow. Assuming that the $90,000 cash flow is received uniformly throughout the year, the payback would be 1% years.

Calculating Payback

The projected cash flows from a proposed investment are:

Year

Cash Flow

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