3. Very Often, it Does Not

3.2. Problem 2: Cashflows after Cutoff

The second problem is that the payback rule ignores all cash flows that occur after the cutoff period. 

  

Example 5

Let's assume a company that follows the payback rule can choose between the following two projects. Again, we assume a cost of capital of 10%:

 

Today Year 1 Year 2 Year 3
Project H -1'000 1'000 0 0
Project J -1'000 500 500 100'000

 

The payback of Project H is 1 year whereas that of Project J is 2 years. Because H returns the capital more quickly, a company that follows the payback rule would opt for Project H.

When computing the NPVs of the projects, we see that this is a big mistake. The payback rule ignores that Project J has a massive cash flow in year 3 (the year after it reaches payback). This cash flow does not enter the investment decision in any way when we rely on the payback rule.

  

\( NPV_{H,10\%} = -1'000 + \frac{1'000}{1.1} = -91 \)

  

\( NPV_{J,10\%} = -1'000 + \frac{500}{1.1}+ \frac{500}{1.1^2}+ \frac{100'000}{1.1^3}= 74'999 \)

  

The NPV rule provides the correct answer. The NPV of Project J (the one with the longer payback) is hugely positive whereas Project H (with the shorter payback) actually destroys value. Clearly, managers are ill-advised to blindly follow the payback rule in such situations...