Payback Period - Estimation of Cash Flows and Determination of Payback Period

Payback Period

Payback period is an investment appraisal metric. This period will indicate the number of years it will take to get back the cash initially invested in a project. The period is calculated using the estimated cash flows, both outflows and inflows.

Cashflow Estimation - Some Principles

Cash flows of a project have to be estimated for a time horizon. The time horizon is the minimum of physical life of the plant, technological life of the plant, or the product market life.

In estimating the cash flows of a project, incremental principles (that considers all incidental effects), separation of investment and financing principle, post-tax principle and consistency principles are employed.

Incremental principle

In an existing company, the cash flows are to be estimated by evaluating the cash flows of the company with the project and without the project. The difference will be incremental cash flows related to the project.

Separation of investment and financing principle

In a standard capital expenditure analysis, interest payment to be made on borrowings is not brought into the picture. Borrowing is considered a financing decision and its impact is included in the cost of capital estimation. Hence cash flow estimates do not have any interest payment of component.

Post-tax principle

Tax impact on the cash flow is considered and after tax cash flows are estimated.

Consistency principle

The inflation expectation built into estimation of revenues and costs and cost of capital have to be consistent or same.

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Some Examples Issues That I came Across Recently

1. Acquisition of a software by a design department.
2. Replacement of boiler tubes.
3. Replacement of an electronic equipment as some cards used in the equipment are not available anymore for replacement (the equipment manufacturer is not supplying those cards anymore as the equipment is phased out for production).

The approval authority for the expenditures wants the concenred departments to calculate the payback period for the expenditure proposals.

Originally Knol 1952

Estimation of Cash Flows for Engineering Economic Analysis

An investment proposal or an expenditure proposal must have estimated benefits and costs for doing engineering economic analysis. For simple proposals, the engineer making the proposal may be able to make these estimates. For complex proposals, involvement of marketing, production, maintenance and other operating departments and accounting department may be necessary. The estimation of benefits and costs are to be made keeping in mind the following principles.


Cash flow Estimation - Basic Principles

Time horizon

Cash flows of a project have to be estimated for a time horizon. The time horizon is the minimum of physical life of the plant, technological life of the plant, or the product market life.

Cash flow principle

In economic analysis, it is actual cash flow that is used. So the time at which actual cash is received or paid is to be estimated along with the amount of cash flow.



In estimating the cash flows of a project, incremental principle (that considers all incidental effects), separation of investment and financing principle, post-tax principle and consistency principles are employed.

Incremental principle

In an existing company, the cash flows are to be estimated by evaluating the cash flows of the company with the project and without the project. The difference will be incremental cash flows related to the project.


Long-term funds principle

The cash flows reflect the benefits that accrue to long-term funds.

Interest exclusion principle - Separation of investment and financing principle

In a standard capital expenditure analysis, interest payment to be made on borrowings is not brought into the picture. Borrowing is considered a financing decision and its impact is included in the cost of capital estimation. Hence cash flow estimates do not have any interest payment  component (interest paid for long term funds).

Post-tax principle

Tax impact on the cash flow is considered and after tax cash flows are estimated.

Consistency principle

The inflation expectation built into estimation of revenues and costs and cost of capital have to be consistent or same.


Thus, in estimating the cash flows of a project, incremental principle (that considers all incidental effects), separation of investment and financing principle, post-tax principle and consistency principles are employed.

Opportunity to increase manufacturing resource productivity - McKinsey Article

June 2012


Stephan Mohr,  an associate principal in McKinsey’s Munich office, Ken Somers,  a consultant in the Antwerp office, Steven Swartz,  a principal in the Chicago office, and Helga Vanthournout, s a consultant in the Geneva office jointly authored an article published in McKinsey Quarterly, 2012 June on the theme Manufacturing Resource Productivity.

They observed that cost of inputs especially raw materials and energy are going up as production and consumption of manufactured goods is going up in emerging countries. Therefore variable cost is going up as a proportion of production expenses.

But companies have a visible opportunity of reducing these variable costs. Companies who make use of these opportunities will have operational stability compared to organization who ignore them and hence likely to suffer volatility.

The opportunities are in four areas: Production process redesign, Product redesign, Value recovery from used products that are with consumers, and Supply circle management.

Processes can be redesigned to save 20 to 30% energy.

Product redesign can be undertaken to reduce material use by 30%. At the same time design changes can be brought in to their potential for recycling and reuse.

The benefit can go up to 50% if the mechanism and recycling and reuse are put in place with bringing consumers into the loop to recover used products from them.

Once a company is successful with these initiatives, it can implement them in its supply partner organizations.

Read the full article
http://www.mckinseyquarterly.com/Manufacturing_resource__productivity_2982

Origins of Industrial Engineering

Even though Frederick Taylor is called the father of industrial engineering, there are scholars who identified the need for efficiency and productivity in engineering activity or manufacturing activity and even developed some principles.

Adam Smith in his book Wealth of Nations right in the first chapter discussed productivity of labor.


On the economy of machinery and manufactures - Charles Babbage , 1832
http://books.google.co.in/books?id=cTNVAAAAMAAJ

The Philosophy of Manufactures: Or an Exposition of the Scientific, Moral,  and Commercial Economy
Published 1835
Andrew Ure, Glasgow, Great Britain
http://archive.org/stream/philosophymanuf01uregoog#page/n5/mode/2up


John Stuart Mill Economics

On What depends the degree of productiveness of productive agents
http://ebooks.adelaide.edu.au/m/mill/john_stuart/m645p/book1.7.html#book1.7

Of Production on a large, and production on a small scale
http://ebooks.adelaide.edu.au/m/mill/john_stuart/m645p/book1.9.html