How to Calculate the Payback Period on KRW 12 Billion of Capital Expenditure
Calculate incremental cash flow before dividing the initial investment by annual profit. This case shows how working capital, maintenance spending, uneven cash recovery, and discounting change the result.
The payback period is the time needed for cumulative incremental cash flow from an investment to recover the initial outlay. Rather than simply dividing by accounting profit, reflect actual cash inflows, operating outlays, maintenance investment, and working capital.
Calculate the difference from the case without the investment
Not all revenue from new equipment is necessarily incremental. If production shifts from existing equipment or replaces sales of another company product, subtract the displaced cash flow. Payroll savings count as cash savings only if staffing actually falls or other expenditure can be avoided. Also distinguish costs already paid from future costs that depend on the investment decision. Payback is a measure for comparing alternatives at the decision date, so start by setting out cash flows without the equipment over the same period and calculating the difference.
Do not subtract depreciation and cash expenditure twice
Acquiring property, plant and equipment and depreciating it differ in timing and nature. If the initial investment has already been included as a cash outflow, do not subtract annual depreciation again as though it were cash expenditure. To include tax effects from depreciation, however, check the actual tax conditions. Separately include the working-capital requirements from increased raw materials and receivables at startup, and cash for regular repairs and component replacements. IAS 16 and IAS 7 provide a basis for distinguishing asset costs from cash flows, while the analyst must specify the assumptions used in the payback calculation.
Consider performance after payback and the time value of money
Simple payback shows how quickly money is recovered, but does not adequately capture earnings after the payback point. Comparing short-lived and long-lived equipment solely by payback can lead to a poor choice. Also calculate discounted payback or net present value and examine disposal costs and residual value. If receipts are concentrated at particular dates rather than arriving steadily, a fractional year based on even recovery throughout the year is also imprecise. Check a conservative path incorporating delivery delays and low initial production yields.
Worked example
Hypothetical example: Equipment acquisition costs KRW 12 billion and initial working capital KRW 2 billion, for an upfront outflow of KRW 14 billion. Once operating, the investment generates KRW 4.5 billion of additional operating cash annually and requires KRW 1 billion of maintenance investment, leaving KRW 3.5 billion a year for recovery. Simple payback is 4 years. If first-year cash flow is only KRW 1.5 billion and each subsequent year generates KRW 3.5 billion, cumulative cash flow at the end of year 4 is KRW 12 billion. Assuming the remaining KRW 2 billion is recovered evenly during year 5, payback is about 4.57 years. This calculation is undiscounted and excludes eventual recovery of initial working capital and residual value.
What to check
- Include only incremental cash flows relative to the case without the equipment.
- Do not subtract both depreciation and the initial acquisition expenditure as cash outflows.
- Reflect working capital and maintenance investment.
- Also examine the remaining useful life after payback, residual value, and discounted cash flows.
Sources and primary materials
This is educational material about research methods. For an actual company decision, verify the filings and primary sources for the relevant period.