Question

How to calculate payback period for uneven cash flows?

Answer 1

Let's understand this with an example.

Cost of project : 1,00,000

Cash flows : for next five years
20,000
30,000
25,000
15,000
20,000

This is calculated by accumulating cash flows statement. Let's make it.

Year Accumulated cash flow
1 20,000
2 50,000 (20,000 + 30,000)
3 75,000
4 90,000

Now as you see, up to fourth year we have recovered 90,000 out of total 1,00,000 cost. We need only 10,000 more to breakeven. In the fifth year, we are gonna earn 20,000 in the 12 months.
If we assume that 20,000 is earned at the same rate, or 10,000 in first six months and 10,000 in next six months. So, after six months in fifth year we have earned 10,000 to recover the total cost.

Hence, the payback period here is 4 years and six months.
Earning of four years : 90,000
Earning of six months in fifth year : 10,000
Total : 1,00,000.

This type of problem is solved only by making this statement, i.e. accumulating cash flow year by year.

Hope this helps you understand, ask in case of doubt.