The method of calculating the payback period by dividing the initial cost by the cash flow during the recovery year and adding prior years’ recovery is called what?

In Finance MCQs, the payback period is one of the most fundamental concepts in capital budgeting. It is used to evaluate the time required for a project or investment to recover its initial cost from the cash inflows generated by the project. The payback period is especially important for firms that need to assess liquidity or prefer investments that return capital quickly. This method provides managers with a simple, clear metric: it tells them how long it will take for the project to “pay back” its original investment.

The method described in this question is the standard calculation technique for projects with uneven cash flows, which is a scenario frequently tested in finance exams. The process involves several steps:

1. Identify cumulative cash flows:
First, sum the cash inflows year by year until the total equals or exceeds the initial investment. This cumulative approach helps track progress toward recovering the invested capital.

2. Determine the recovery year:
The recovery year is the year in which cumulative inflows meet or surpass the original investment. This identifies the point where most of the initial cost has been recovered.

3. Fractional recovery adjustment:
If the cumulative cash flow in the recovery year exceeds the remaining unrecovered investment, divide the remaining amount by the cash inflow of that year. This provides a fractional year to add to the total payback period.

4. Add prior years:
Finally, combine the full years before the recovery year with the fractional year to calculate the total payback period accurately.

Example:
Suppose a project costs $100,000 and generates $30,000, $40,000, and $50,000 over three successive years:

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  After Year 1: $30,000 recovered

  
  


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  After Year 2: $70,000 recovered

  
  


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  Remaining $30,000 to recover in Year 3: $30,000 ÷ $50,000 = 0.6 year

  
  


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  Total payback period = 2 + 0.6 = 2.6 years

  
  

This calculation demonstrates how the method accounts for uneven cash flows, providing a precise estimate of the time required to recoup the investment.

Why other options are incorrect:

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  Original period is not a standard term in finance. While it may sound like a period associated with investment, it does not describe the method of calculating payback and is therefore incorrect.

  
  


• 
  

  Investment period refers to the total duration of a project but does not specifically measure how quickly the initial investment is recovered.

  
  


• 
  

  Forecasted period relates to projecting future cash flows but does not measure actual investment recovery.

  
  

The payback period method is widely used in corporate finance because of its simplicity and ease of interpretation. Managers often employ it as a preliminary screening tool: projects with shorter payback periods are preferred, especially when liquidity is a concern or when rapid recovery of capital is desired.

However, it is important to understand its limitations: the payback period ignores cash flows occurring after the payback is achieved and does not account for the time value of money. Because of this, more comprehensive methods such as Net Present Value (NPV) or Internal Rate of Return (IRR) are used alongside the payback period for a full evaluation of project profitability.

In conclusion, the method of calculating the time required to recover an investment by dividing the remaining unrecovered cost by the cash inflow in the recovery year and adding prior years is called the Payback period. It is a crucial tool in finance for assessing investment liquidity and short-term recovery. Therefore, in finance MCQs, the correct answer is Payback period, making option C the right choice.