PAYBACK PERIOD


Organisations sometimes require that the initial outlay on a project be recoverable within some specified cut off period; the payback period. The payback period of a project is found by counting the number of years or periods it takes before cumulative forecasted cash flows equal the initial investment.

To use the rule, the investor has to decide on an appropriate cut off date. Unfortunately, any such rule will inevitably be arbitrary as the worth of an investment has almost nothing to do with its length.

EXAMPLE

Three projects that are to be assessed against a payback rule with a cutoff period of 3 years:

TABLE

Comparison of payback periods and net present values

YEAR	0	1	2	3	4	NPV PROJECT (8%)	PAYBACK PERIOD (YEARS)
A	(3000)	1000+	1000	1000	4000	2331	3
B	(3000)	0	0	3000	4000	2150	3
C	(3000)	0	0	1000	10000	4763	4

Projects A and B repay the initial investment in 3 years. Project C repays it in 4 years yet has a substantially higher NPV. Therefore, Project C is the better project but would be discarded under the payback rule, in favour of either A or B. Another feature of the payback rule is that it gives equal weight to cash flows irrespective of when they occur before the cutoff date. Criticism of this equal weighting has led to a modification known as the discounted payback rule.



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