The payback method is a popular capital budgeting technique used by financial managers. It is defined as the time it takes to “payback’ the initial investment. Let’s quickly demonstrate this technique through an example:

Example: A firm has found the following two projects. Based on the payback method which project should the firm choose?

Answer:

Payback Period = Number of years + $ not yet paid in final period of  “payback”/Cash flow  during final year of payback

Payback of Project Alpha = 3 +20,000/100,000 = 3.2 years

Payback of Project Beta = 2 +50,000/100,000 = 2.5 years

The payback period of project beta is shorter than the payback period of project alpha. Therefore using this capital budgeting technique, project beta would be preferred.

Strengths and Weaknesses:

Weaknesses:

The payback period has a number of flaws. First the payback rule has an arbitrary cut off and so does not take into account any payments after the payback period. This means projects with large cash flows during its early stage and low/nil cash flows in the later stages would be preferred to a project with low cash flows during its early stage and very large cash flows during the stage after the payback period. For this reason, the project favours short term as oppose to long term projects.

Furthermore the payback period has no time value consideration. It does not distinguish between high risk and low risk investments and the calculation does not indicate whether the project would “add value”.  In addition, there is no comparable guide to determine whether the project should be pursued. i.e. should we pursue a project if it has a payback period less then 2 years, 4 years or 6 years. By contrast, NPV and IRR immediately indicate whether the project should or should not be pursued.

Strengths:

Despite this however the payback period is one of the most popular capital budgeting techniques. Why?

The Payback period technique is useful because it is simple, quick & easy to understand. Its simplicity and speed helps to explain why it is used for many small decisions. For example imagine a firm had a machine that has incurred wear and tear and does not operate to its full efficiency. The firm can either leave it as it is and incurr an additional $50 in costs a year, or pay $100 to repair it. Quite clearly it would be inefficient to conduct an NPV analysis based on the discount rate of the firm as a whole. In this situation a manager would identify a payback period of two years as his/her means of justifying the project.

This entry was posted on Wednesday, May 13th, 2009 at 1:18 am and is filed under Finance. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.