Payback Method

Learning Objective 3 Use and evaluate the payback and discounted payback methods

to calculate the time it takes to recoup the investment

We now consider the third method for analyzing the financial aspects of projects. The payback method measures the time it will take to recoup, in the form of expected future cash flows, the net initial investment in a project. Like the NPV and IRR methods, the payback method does not distinguish among the sources of cash flows, such as those from operations, purchase or sale of equipment, or investment or recovery of working capital. As you will see, the payback method is simpler to calculate when a project has uniform cash flows than when cash flows are uneven over time.

Uniform Cash Flows

The hybrid bus Vector is considering buying costs $648,900 and generates a uniform $180,000 cash inflow every year of its 5-year expected useful life. The payback period is calculated as follows:

$\begin{array}{l} Payback period & = & \frac{Net initial investment}{Uniform increase in annual future cash flows} \\ = & \frac{$ 648,900}{$ 180,000} = 3.6 {years}^{6} \end{array}$

⁶ Cash inflows from the new hybrid bus occur uniformly throughout the year, but for simplicity in calculating NPV and IRR, we assumethey occur at the end of each year. A literal interpretation of this assumption would imply a payback of 4 years because Vectorwill only recover its investment when cash inflows occur at the end of year 4. The calculations shown in the chapter, however, betterapproximate Vector’s payback on the basis of uniform cash flows throughout the year.

The payback method highlights liquidity, a factor that often plays a role in capital budgeting decisions, particularly when the investments are large. Managers prefer projects with shorter payback periods (projects that are more liquid) to projects with longer payback periods, if all other things are equal. Projects with shorter payback periods give an organization more flexibility because funds for other projects become available sooner. Also, managers are less confident about cash flow predictions that stretch far into the future, again favoring shorter payback periods.

Unlike the NPV and IRR methods where managers select an RRR, under the payback method, managers choose a cutoff period for the project. Projects with payback periods that are shorter than the cutoff period are considered acceptable, and those with payback periods that are longer than the cutoff period are rejected. Japanese companies favor the payback method over other methods and use cutoff periods ranging from 3 to 5 years, depending on the risks involved with the project.^* In general, modern risk management calls for using shorter cutoff periods for riskier projects. If Vector’s cutoff period under the payback method is 3 years, it will reject the new bus.

The payback method is easy to understand. As in DCF methods, the payback method is not affected by accrual accounting conventions such as depreciation. Payback is a useful measure when (1) preliminary screening of many proposals is necessary, (2) interest rates are high, and (3) the expected cash flows in later years of a project are highly uncertain. Under these conditions, companies give much more weight to cash flows in the early periods of a capital budgeting project and to recovering the investments they have made, thereby making the payback criterion especially relevant.

Two weaknesses of the payback method are that (1) it fails to explicitly incorporate the time value of money and (2) it does not consider a project’s cash flows after the payback period. Consider an alternative to the $648,900 hybrid bus. Another hybrid bus, one with a 3-year useful life and no terminal disposal value, requires only a $504,000 net initial investment and will also result in cash inflows of $180,000 per year. First, compare the payback periods:

$\begin{array}{lll} Bus 1 & = & \frac{$ 648,900}{$ 180,000} & = & 3.6 years \\ Bus 2 & = & \frac{$ 504,000}{$ 180,000} & = & 2.8 years \end{array}$

The payback criterion favors bus 2, which has a shorter payback. If the cutoff period were 3 years, bus 1 would fail to meet the payback criterion.

Consider next the NPV of the two investment options using Vector’s 8% required rate of return for the hybrid bus investment. At a discount rate of 8%, the NPV of bus 2 is $begin inline style negative $ text 40,140 end text end style$ (2.577, the present value annuity factor for 3 years at 8% per year from Table 4, times $inline style begin inline style $ text 180,000 end text equals ? $ back space ? text 463,860 end text end style$ , minus net initial investment of $504,000). Bus 1, as we know, has a positive NPV of $69,840 (from Exhibit 22-2). The NPV criterion suggests Vector should acquire bus 1. Bus 2, which has a negative NPV, would fail to meet the NPV criterion.

The payback method gives a different answer from the NPV method in this example because the payback method ignores cash flows after the payback period and ignores the time value of money. Another problem with the payback method is that choosing too short a cutoff period can lead to projects with high short-run cash flows being selected. Projects with long-run, positive NPVs will tend to be rejected. Despite these differences, companies find it useful to look at both NPV and payback when making capital investment decisions.