Certified Management Accountant Practice Exam

The payback period is a financial metric used to determine how long it takes for an investment to generate an amount of cash equal to the initial investment cost. It specifically focuses on the time it takes for cash inflows (from the investment) to cover the cash outflows (the initial investment).

The correct formula for calculating the payback period is derived from dividing the initial net investment by the annual expected cash flow. This captures the essence of the payback period’s purpose: to assess how quickly an investment can “pay back” its initial costs through generated cash flows.

For example, if an investment requires an initial cash outlay of $100,000 and is expected to generate $25,000 annually, the payback period would be calculated as follows: $100,000 (initial net investment) divided by $25,000 (annual expected cash flow), resulting in a payback period of 4 years.

This approach provides a clear and straightforward metric for investors to evaluate the risk associated with an investment, focusing on liquidity and the recouping of invested capital.