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Further to my earlier article on Accounting Rate of Return, let’s look at another simple investment appraisal method called Payback Period.

This method seeks to determine how long it takes for the investment project to pay back its initial capital cost.

Illustration:

Let’s say we have two project A & B, having the following initial capital cost, cash inflows and timing

Project A:

Payback period = 3 years

Project B:

Payback peiod=2 years

Using the payback period methodology, the analysts merely see how long or how fast the investment can be recouped.

In the aforesaid situation, we see that by investing in Project B, the company has a faster payback period of 2 years instead of Project A which takes a bit longer which is 3 years.

So what are the advantages and disadvantages of using the Payback period method?

The advantages are:

• this method is very easy to understand and to explain to other people;
• it requires the proposer to consider and to collect only the forecasts of the initial capital outlay and estimated cash inflows in the next few yeras, typically no more than five years
• it gives a “result” very quickly without much analysis needed-there is no need to compute a discount rate)
• lastly, if forecasts into the future are unlikely to be accurate, due to technological changes for example, it is considered “less risky” because it is only taking into account those cashflows which are easier to forecast well.

However, its following disdvantages outweight the abovesaid advantages:

• this method ignores the time value of money. That is it assumes that if a company has an investment decision rule which sets payback on projects at, say four years, the company will be indifferent as to whether its investment is recouped in the first year of the project or the third year of the project;
• it ignores any cashflows which might occur outside the “Four-year rule”(say). Thus the company may reject a very lucrative project in favor of a less profitable one because the former recoups its investment over a six-year period whilst the latter recoups much less cash but within the four-year(say) payback period;
• this method automatically favors short-term over long-term investments[the company should preferably have a range of investment projects with differing time horizon thus retaining a flexible approach to new opportunities while capitalizing on long-term projects which ensures that the company keeps pace with technological or other research developments that affect its future viability;
• it does not have a clear decision criteria as to whether to accept or reject an investment project. The cut-off point is ambiguous. For example when is the investment stage of a project considered to be finishd? When the investment project begins to generate cash or automatically after the first year? This ambiguiy leads to subjective decision-making rather than clear-cut decision rules and
• thinking that Paybak is “less risk” can be misleading. The opportunity cost of capital takes into account the increased risks associated with forecasting in future years whereas Payback just ignores these cashflows altogehter. This therefore is really not “less risky” but just more inaccurate!

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