2. Sometimes, Payback Works

Example 2

Consider the following two mutually exclusive projects:

  

Today Year 1 Year 2 Year 3 Year 4 Year 5
Project A -1'000 500 800 0 0 0
Project B -1'000 0 0 500 800 0

 

Project A has a payback period of 2 years, whereas the payback period of project B is 4 years. According to the payback rule, we would therefore opt for project A, because it is quicker to return the investment. We reach the same conclusion when using the slightly more complicated NPV criterion. Assuming a cost of capital of 10%, the NPV of Project A is positive whereas the NPV of Project B is negative:

 

\( NPV_{A,10\%} = -1'000 + \frac{500}{1.1}+\frac{800}{1.1^2}=116 \)

\( NPV_{B,10\%} = -1'000 + \frac{500}{1.1^3}+\frac{800}{1.1^4}=-78\)

 

In the investment constellation of Example 2, NPV and payback therefore do equally well.

 

Example 3

 Let's consider another set of projects. We continue to assume a cost of capital of 10%.

 

Today Year 1 ... Year 50
Project C -1'000 2'000 0
Project D -1'000 0 0 213'438

 

According to the NPV rule, both projects are equally attractive, because both have an NPV of 818:

 

\( NPV_{C,10\%} = -1'000 + \frac{2'000}{1.1} = 818 \)

\( NPV_{D,10\%} = -1'000 + \frac{213'438}{1.1^{50}} = 818 \)

 

The payback rule does not quite agree. Project C repays the investment within 1 year whereas it takes 50 years for project D to reach payback. While it is technically correct that both projects are equally good in terms of value creation, a payback period of 50 years (and no cash flows in between) would make most financial managers and investors quite nervous. 

Therefore, there are also situations when payback does better than NPV in a real-world setting.