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How to Calculate a Payback Period with Inconsistent Cash Flows - YouTube
Channel: Alanis Business Academy
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Welcome to Alanis Business Academy.
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I'm Matt Alanis and this is How to Calculate
a Payback Period with Inconsistent Cash Flows.
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In our last we learned about the payback period
as well as how to calculate the payback period
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assuming consistent cash flows.
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For access to this video select the link above
or go to the Alanis Business Academy YouTube
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channel page and search for the video titled
How to Calculate the Payback Period.
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Unfortunately cash flows are anything but
consistent, which makes the basic formula
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for calculating a payback period somewhat
unhelpful.
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So in this video we are going to walk through
how to calculate the payback period when our
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expected future cash flows fluctuate from
one period to the next.
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The formula to calculate the payback period
assuming inconsistent cash flows is A plus
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the result of B divided by C.
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This probably makes little sense at this point,
but let me attempt to elaborate.
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In this formula, A represents the last period
with negative cash flow.
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Essentially this is the period just before
we recover our initial investment.
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B represents the amount of cash that is remaining
at the end of A. C represents the total amount
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of cash generated in the period immediately
following A. If this is still somewhat unclear
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that's okay.
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It will make more sense once we work through
a problem.
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Lets assume that we will be investing $9,000
in a project.
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Since this is our investment so we include
the $9,000 in parenthesis, which represents
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a negative figure or cash outflow.
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The Abbreviation CF stands for cash flow,
and the subscript 0 indicates the period.
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A period of 0 represents the present time.
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Assume that based upon our calculations that
we project to receive positive cash flows
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of $2,000, $2,500, $3,750, and $4,500 in periods
one through four respectively.
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When calculating the payback period for inconsistent
cash flows I find it helpful to use a two-column
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approach.
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The first column contains our expected cash
flows in order from when we expect to receive
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them.
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The second column contains the remaining cash
need to cover our initial investment of $9,000.
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Now that we've organized our problem we simply
need subtract each of our expected future
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cash flows from our initial investment.
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So in the first period we subtract $2,000
from $9,000 to get $7,000.
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This means that after the first period we
still need $7,000 to cover our initial investment.
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In the second period we subtract our expected
cash flows from year 2 of $2,500 from our
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remaining unrecovered investment of $7,000
to get $4,500.
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For year 3 we subtract expected cash flows
of $3,750 from $4,500 to get $750.
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At this point we only need $750 in positive
cash flow to break-even and cover our startup
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costs of $9,000.
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Now in year 4 we expect to receive $4,500
in cash, which is much greater than the $750
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needed to cover our initial investment.
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Since we will experience positive cash flow
in year 4, year 3 represents the last period
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that we will have negative cash flow.
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As a result, year 3 presents A. So already
we know that our payback period is going to
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be somewhere in between 3 and 4 years.
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Now that we have A we need to see if we have
enough information to solve this problem.
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Once again, B represents the amount of cash
that is remaining at the end of A. Since we
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know that A is period 3 or the third year,
and the corresponding cash remaining at the
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end of A is $750, $750 will be used as B.
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The last variable in our formula is C, which
represents the total amount of cash generated
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in the period immediately following A.
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This is $4,500 since we expect to receive
$4,500 in cash at the end of year 4, and year
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4 is the period immediately following A.
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At this point we simply substitute these values
into their corresponding variable and solve.
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Doing so gives us a payback period of 3.17
years or 3 years and 2 months if you convert
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the decimal into months.
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Whether this payback period is acceptable
will depend in large part on the other opportunities
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that we have to generate positive cash flow.
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This has been How to Calculate a Payback Period
with Inconsistent Cash Flows.
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For questions or comments please utilize the
comment box below and I'll do my best to get
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back to those in a timely fashion.
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For access to additional videos on capital
budgeting as well as other business topics
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be sure to subscribe to Alanis Business Academy
and also remember to like and share this video
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with your friends.
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Thanks for watching.
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