Overview
This lecture covers the Payback Rule as an alternative method for capital budgeting, explains how to calculate payback periods, and discusses its pros and cons.
The Payback Rule: Definition & Usage
- The Payback Rule is an investment decision method that measures how long it takes to recover a project's initial cost.
- Accept a project if its payback period is less than a specified cutoff; otherwise, reject it.
- The payback period is calculated as the number of years needed to recover the initial investment from the project's cash inflows.
Example: Calculating Payback Periods
- For Project A: Initial investment = $100; Cash inflows: $10 (Year 1), $60 (Year 2), $80 (Year 3).
- After Year 1: $90 left to recover; after Year 2: $30 left; partway through Year 3, investment is fully recovered.
- Payback period for Project A = 2 + (30/80) = 2.375 years.
- For Project B: Initial investment = $100; Cash inflows: $70 (Year 1), $50 (Year 2).
- After Year 1: $30 left to recover; partway through Year 2, investment is fully recovered.
- Payback period for Project B = 1 + (30/50) = 1.6 years.
Advantages of the Payback Rule
- Simple and easy to apply without complex calculations.
- Widely used: 91% of firms consider payback period when evaluating projects.
Limitations of the Payback Rule
- Ignores the time value of money (does not discount future cash flows).
- Only considers cash flows within the payback period, ignoring later inflows.
- May prefer projects with quicker payback, even if less valuable overall.
- No objective criteria for what is an "acceptable" payback period; cutoff is set arbitrarily by management.
Key Terms & Definitions
- Payback Period — Time needed to recoup the initial investment of a project through its cash inflows.
- Capital Budgeting — The process of evaluating and selecting long-term investments.
- Time Value of Money — The principle that money now is worth more than the same amount in the future.
Action Items / Next Steps
- Practice calculating payback periods for sample projects.
- Review the limitations of the payback rule and compare it to the Net Present Value (NPV) rule.