5. Summary

This section has introduced the payback rule, an investment decision criterion that is fairly popular among practitioners, especially in smaller firms. The payback rule is very simple:

 

Accept all projects that return the initial investment within a predefined period of time (years).

 

Payback is an ad hoc profitability measure that has severe flaws:

  • The cutoff period is often randomly determined
  • The payback rule ignores the size of the project
  • The payback rule ignores all the cash flows that occur after the cutoff period
  • The payback rule ignores the time value of money.

 

The latter flaw can be partially addressed by using the discounted payback, which relies on present values. Yet the other flaws remain.

 

We therefore strongly advise against using the payback rule as an investment decision criterion. More often than not, it will fail to distinguish between good and bad project (alternatives) and therefore provide no useful guidance for financial managers.

 

Still, it is important to understand what payback does, as many investors will ask for that metric. Therefore, we should always report it as a complimentary information to the project's NPV and IRR. But we should also be able and ready to explain, why we should not invest based on payback.