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.
.