Capital Budgeting

Pay Back Period and Net Present Value

Learning Objectives

After reading this chapter, you are expected to learn about:

To understand concept of pay back period

To understand concept of net present value

To calculate pay back period

To calculate net present value

To decision rule using pay back period

To decision rule using net present value

Introduction

Present Value Concept

The project evaluation is done using time value of money and with out time value of money. As time pass the value of money changes. For example if one borrows Rs 100 from bank, the bank will charge some interest. The interest is generally charged per annum. Let’s assume that the interest charged is 10% per annum, it means the value of money is changing at 10 percent every year. If Rs 100 is used for one year period, the next year its value is 110. The 10% change indicates that Rs 100 spent today is equivalent to Rs 110 a year hence. The basket of goods that one can buy today for Rs 100, a year hence it will cost Rs 110 if the rate of change of money is Rs 10% per annum. In the same way Rs. 100 spent today is equivalent to Rs 90.90 a year before.

The evaluation of project is done by evaluating the pay back period as well as net present value. When one wants to check whether the project under consideration will be viable or not, pay back period as well as net present value of the project.

Pay back Period

To start the project, initial investment is required. As the project starts generating revenue, the initial investment is recovered gradually. The cumulative revenue will recover the investment made. Time required to recover this amount is called as Pay back period.