Reading: Payback Rule

The third problem is that the payback rule ignores the time value of money. We know from the whole discussion of present values and net present values, that it is not enough for projects to simply repay the investment: A project that just returns its investment capital will generate zero return for the investors!

We have encountered that problem already with Project H in Example 5. With an initial investment of 1'000 and a cash inflow of 1'000 in year one, that project had a payback of 1 year and, therefore, looked attractive according to the payback rule.

As the computation of the NPV has shown, however, the project destroys value because it does not allow the investors to earn an adequate risk-adjusted return!

The fact that the traditional payback rule ignores the time value of money is a third major flaw of this ad hoc investment criterion. 

Some practitioners try to counter this flaw by using the so-called Discounted Payback or Modified Payback. Next, we take a quick look at this revised payback rule.