What is the updated recovery period?
The updated payback period is a capital budgeting procedure used to determine the profitability of a project. An updated payback period provides the number of years it takes to break even from initial expenses, discounting future cash flows and recognizing the time value of money. The metric is used to assess the feasibility and profitability of a given project.
The most simplified recovery period , which simply divides the total cash expenses for the project by the average annual cash flows, does not provide as precise an answer to the question of whether or not to undertake a project since it involves a single initial investment and does not does not take into account the time value of money.
Updated recovery period
How to calculate the updated recovery period
To begin, the periodic cash flows of a project must be estimated and presented by period in a table or spreadsheet. These cash flows are then reduced by their present value factor to reflect the discounting process. This can be done using the current value function and an array in a spreadsheet.
Then, assuming the project begins with a large cash outflow or an investment to start the project, future discounted cash inflows are offset against the initial investment outflow. The updated recovery period process is applied to the cash inflow of each additional period to find the point at which the inflows are equal to the outflows. At this point, the initial cost of the project has been reimbursed, with the payback period reduced to zero.
What does the updated recovery period tell you?
A general rule to consider when using the updated payback period is to accept projects with a payback period shorter than the target period. A business can compare its break-even date required for a project to the point where the project will break even based on the discounted cash flows used in the analysis of the updated payback period, to approve or reject the project.
Key points to remember
- PLR is used as part of investment budgeting to determine which projects to undertake and offers a more accurate result than the standard payback period because it takes into account the time value of money.
- The formula for the updated payback period shows how long it will take to recover an investment based on observation of the present value of the project’s projected cash flows.
Example of use of the recovery period with discount
Suppose Company A has a project requiring an initial disbursement of $ 3,000. The project is expected to yield $ 1,000 per period for the next five periods, and the appropriate discount rate is 4%. The calculation of the updated recovery period begins with the – $ 3,000 disbursement during the departure period. The first period will experience a cash flow of + $ 1,000.
Using the present value discount calculation, this figure is $ 1,000 / 1.04 = $ 961.54. Thus, after the first period, the project still needs $ 3,000 – $ 961.54 = $ 2,038.46 to reach the break-even point. After discounted cash flows of $ 1,000 / (1.04)2 = $ 924.56 for the second period and $ 1,000 / (1.04)3 = $ 889.00 for the third period, the net balance of the project is $ 3,000 – ($ 961.54 + $ 924.56 + $ 889.00) = $ 224.90.
Therefore, after receiving the fourth payment, which is reduced to $ 854.80, the project will have a positive balance of $ 629.90. Therefore, the updated recovery period is during the fourth period.
The difference between the recovery period and the updated recovery period
The payback period is the time it takes a project to break even with cash recoveries using nominal dollars. Alternatively, the updated payback period reflects the time it takes to reach the breakeven point of a project, not only based on cash flows but also on their timing and the prevailing rate of return on the market.
These two calculations, although similar, may not give the same result due to discounted cash flows. For example, projects with higher cash flows towards the end of their useful life will benefit from a larger discount due to compound interest. For this reason, the recovery period may return a positive number, while the updated recovery period returns a negative number.