Payback Analysis

 The payback method is a common measure of the relative time value of a project. It determines the time it takes for the accumulated benefits to equal the initial investment. Obviously, the shorter the payback period, the sooner a profit is realized and the more attractive is the investment. The payback method is easy to calculate and allows two or more activities to be ranked. Like the net profit, though, it does not allow for the time value of money.

The payback period may be computed by the following formula:

Overall cost outlay    (A x B) + (C x D) Years + Installation time (G)

-----------------------=-------------------------------= -------------------------------

Annual cash return        5      +       2                     Years to recover

Elements of the formula:

(A) Capital investment (includes escalation costs)

(B) Investment credit (i.e., 1.00 - 0.08 = 0.92; must use current rate' 

(C) Cost investment (Le., site preparation-includes escalation)

(D) Company's federal income tax bracket

(E) State and local taxes

(F) Life of capital (expected)

(G) Time to install system 

(H) Benefits and savings

(1) Projects benefits (includes escalation)

(2) Depreciation (Capital investment - Salvage  :- Expected Life) 

(3) State and local taxes (percent)

(4) Benefits before FIT (federal income tax): (1) - (2) - (3) = (4)

(5) Benefits after FIT:.(4)  - [(4) x (D)]

Example of Calculation Elements

(A) Capital investment in a new computer                                      $200,000

(B) Investment credit difference (100% - 8% investment credit)                  92/

(C) Cost investment (site preparation)                                                      $ 25,000                                          

(D) Company’s income tax bracket difference                                               54%

(100% - 46%)

(E) State and local taxes                                                                                    2%

(F) Life of capital (no salvage value)                                                          5 years

(G) Time to install system                                                                           1 year  

(H) Benefits (include escalation or inflation)                                           $250,000                                   

Calculation

(1) Benefits before depreciation and taxes (H)

(2) (2) Less depreciation {$200,000(A)15[Life(FJJ}

(3) Less state and local taxes [$200,000 X O.OUE)]

(4) (4) Benefits before FIT

             Less tax difference ($206,000 x 0.46)

(5) Benefits after FIT

Formula calculation

{$200,000(A) x 0.92(B)} + {$25,000(C)x 0.54(D)}

---------------------------------------------------------------- =

           $111,240                +            $40,000

               (5)                                         (2)

                                                                                                                     197,500

                                                                                       ($184,000+13,500) or -------------

                                                                                                                           151,240

              $ 197,500

            ---------------= 1.3 years plus installation time (G)

                                = 2.3 years to recover investment

     2 years and 4 months is the payback period