Question

The ‘Payout Time' or ‘Payback Period' is best defined as

• A. Time to recover total capital investment from profit
• B. Time to recover fixed capital investment from cumulative cash flow
• C. Total project life divided by annual revenue
• D. Time to reach break-even point after start-up

Hint:

Payback Period Equation: \[ \text{Payback Period} = \frac{\text{Fixed Capital Investment}}{\text{Net Annual Cash Flow}} \] Remember that Net Cash Flow = Net Profit + Depreciation. Depreciation must be added back because it does not represent an actual physical outflow of cash.

Answer 1

The Correct Option is B

Concept: The payback period (or payout time) is a standard financial metric used to evaluate investment risk. It estimates the time required for a project to generate enough cumulative cash inflow to recover its initial capital expenditures.

Step 1: Understanding capital breakdown components.
Total Capital Investment (TCI) consists of two components: Fixed Capital Investment (FCI, the capital required for land, equipment, piping, structures) and Working Capital (WC, the liquid capital needed to run day-to-day operations, which is recovered at the end of the project life). Because working capital stays liquid within the company, the primary financial risk lies in recovering the sunk asset investment represented by the Fixed Capital Investment.

Step 2: Formulating the payback period equation.
The payout time is calculated using cash flows after taxes but before deducting depreciation expenditures (since depreciation is a non-cash accounting ledger entry). Mathematically, for uniform annual net cash flows: \[ \text{Payout Time} = \frac{\text{Fixed Capital Investment (FCI)}}{\text{Annual Net Cash Flow (Profit after taxes + Depreciation)}} \] This ratio measures how long it takes for the cumulative cash flows generated by the asset to balance out the initial Fixed Capital Investment outlay. This definition matches option (2).