Capital Budgeting - Risk Analysis Using Payback Period Method

**Summary (100 words):**
Risk analysis using the Payback Period Method evaluates how quickly an investment recovers its initial cost, serving as a basic indicator of project risk. Projects with shorter payback periods are considered less risky since they recover funds sooner and reduce exposure to future uncertainties. The method focuses on the timing of cash flows—front-loaded projects with early inflows carry lower risk than back-loaded ones. Although simple and easy to apply, it ignores the time value of money and cash flows beyond the payback period. Therefore, it is best used as a preliminary tool alongside NPV or IRR methods.

1. Risk analysis using payback period method Sundar b n Assistant professor

2. Risk Analysis Using Payback Period Method The Payback Period Method measures how long it takes for a project to recover its initial investment from expected cash inflows. In risk analysis , it is used to assess how uncertainty in cash flows affects the recovery time. Projects with shorter payback periods are considered less risky , as they recover the investment faster and reduce exposure to future uncertainties. To analyze risk, managers often: Compare different scenarios (optimistic, pessimistic, and most likely). Use probabilities to estimate the expected payback. Thus, the payback period helps in identifying projects that ensure quicker and safer returns, though it ignores cash flows after recovery and the time value of money.

3. Example 1 – Simple Payback under Risk

4. Example 2 – Comparing Projects by Risk Particulars Project A Project B Initial Investment ₹2,00,000 ₹2,00,000 Annual Cash Inflow (Most Likely) ₹50,000 ₹60,000 Pessimistic ₹40,000 ₹30,000 Optimistic ₹60,000 ₹90,000

5. Year Cash Inflow (undiscounted) Discounted Cash Flow (cost of capital = 10%) –100,000 –100,000 1 40,000 36,364 2 40,000 33,058 3 40,000 30,053 4 40,000 27,321 interpolation: payback ≈ 3 + ( (100,000 – 99,475) / 27,321 ) ≈ 3.0192 years.

6. Based on timing of cash flow Key Point Explanation Risk depends on cash flow timing Early inflows → lower risk; late inflows → higher risk Payback reflects timing impact Shorter payback = lower uncertainty Brigham’s view Payback is a useful, simple risk indicator but not a stand-alone decision rule Decision implication Prefer projects with quicker recovery and more front-loaded cash flows under risk

7. Based on timing of cash flow Year Project A (Front-Loaded) Project B (Back-Loaded) 1 60,000 10,000 2 50,000 20,000 3 40,000 40,000 4 — 80,000 Two projects each cost ₹100,000 and both have the same total inflows of ₹150,000, but timing differs:

8. Reference Brigham, E. F., & Ehrhardt, M. C. (2019). Financial Management: Theory and Practice (16th ed.). Cengage Learning.