THE PAYBACK RULE (PB)
- Payback period: the amount of time required for an investment to generate cash flows sufficient to recover its initial cost.
- A cutoff period is established
- Payback Rule (PB) method usually use with small investment project.
There are two types of cash flows to calculate payback period:
- For annuity
Payback period= initial investment/annual cash inflow
- For non-annuity
Calculate cumulative cash inflows on year to year basis until the initial investment is recovered.
Project Decision:
- if PB period<cutoff period or number of prespecified year=> accept the project.
- if PB period>cutoff period or number of prespecified year => reject the project.
Advantages for Payback Rule
- Easy to understand
- Adjusts for uncertainty of later cash flows.
- Biased towards liquidity
Disadvantages for Payback Rule
- Ignores the time value of money
- Requires an arbitrary cutoff point
- .Ignores cash flows beyond the cutoff date.
- Biased against long-term projects, such as research and development, and new projects
Example 1:
Company invests $1,000 returning an annuity of $244 per year for five year. If a particular cutoff time is three years and assumes that company uses Payback Rule method to evaluate project, is this project taken?
Solution:
Payback period=initial investment/ annual cash flow = 1,000/244=4.1 years
Cutoff time = 3 years
Payback period=4.1> cutoff period=3, so company should reject this project.
Example 2:
There are five projects to consider for investment chance using Payable Rule.
Assume a particular cutoff time is two year.
- Project A: payback period = 2.6 year because the sum of the cash flows for first two years is $70 and leave $100-$70=$30 and cash flow at third year is $50, so $30/$50=0.6 year
- Project B: it never pays back because the cash flows never total up to the original investment.
- Project C: Payback period=4 year.
- Project D: there are two different payback periods are either 2 year or 4 year. Payback period is calculated doesn’t guarantee a single answer.
- Project E: payback period=six month. It is obviously unrealistic, but it does pay back in six months, thereby illustrating the point that a rapid payback does not guarantee a good investment.
According to payback rule, investor will accept Project D and E and reject Project A,B and C.
Source:
- Phnom Penh HR
- Mcgraw-Hill – Fundamentals Of Corporate Finance