Reading: Payback Rule

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1. Introduction

Especially in smaller companies, management often requires that the initial investment of a project can be recovered within a predefined period of time. For example, such a requirement could be that a project pays back the initial investment within 5 years. We can find the payback period of a project fairly easily: Count the number of years it takes until the sum of all future cash flows equals the initial investment.

  

Example 1

Let's consider a simple Example:

 

Today Year 1 Year 2 Year 3
Project Cash Flow -10'000 4'000 6'000 5'000

  

The initial investment of the project is 10'000. Subsequently, it takes 2 years for the project to pay back this initial investment: Together, the cash flows of year 1 and year 2 equal 10'000. The project's payback period is therefore 2 years.

 

Managers who follow the payback rule invest in projects with a payback period shorter or equal to the predefined limit. For example, as mentioned above, the payback rule could state that projects have to recover the initial investment within 5 years. According to that rule, we would invest in the project presented above, because it's payback of 2 years is much shorter than the acceptable payback period of 5 years.

 

Assuming a cost of capital of 10%, we can see that the payback rule and the NPV criterion lead to the same investment decision: The project is financially attractive.

 

 NPV = -10'000+\frac{4'000}{1.1}+\frac{6'000}{1.1^2}+\frac{5'000}{1.1^3}=2'352

 

The payback rule is very popular among practitioners. This section therefore takes a closer look at this rule and discusses its advantages and disadvantages.

 

As we will see, the payback rule is a flawed investment criterion. We should never solely rely on payback when deciding about capital investment. What we should do, however, is report payback along with other, more reliable investment decision criteria, namely the NPV and the IRR.