Lets quickly look at an example to how the payback period method works. Say a firm is handed a project where the initial investment is £100,000, and the cash flows for the next 5 years are £20,000, £40,000, £25,000, £15,000 and £30,000 respectively. This can be shown in Table 1.2:
Year
Cash flows (£)
0
– 100,000
1
20,000
2
40,000
3
25,000
4
15,000
5
30,000
Table 1.2
We can also write down investments like the preceding with the notation:
(-£100,000, £20,000, £40,000, £25,000, £15,000, £30,000)
From the table we can se that the investment period would be after 4 years as £20,000 + £40,000 + £25,000 + £15,000 = £100,000. By looking at the multiplication on the last sentence it shows how easy it actually is to calculate the payback period, which is one of its biggest advantages. It allows the managers evaluation process to be done within a relative short time. Companies with limited cash are usually looking for the fastest recovering projects, as it will enhance the reinvestment possibilities for such firms.
However since the payback period method is so simple it is no surprise that it comes with a lot of flaws and shortcomings. The two biggest disadvantages for the PBP method is that it doesn’t take the timing of cash flows into consideration and it ignores the cash flows after the payback period. Lets start with the first disadvantage.
If we compare project A and project B, where both have a payback period of 2 years. But project A has a cash flow of £40,000 the first year and £80,000 the second, while the cash flows for project B are £80,000 for the first year and £40,000 for the second. Since the large cash flows come first for project B, the net present value of the project is considerably higher even though the payback period for the two projects are identical. Hence the problem will be that when comparing the two projects with each other using the payback period it will be impossible to tell which one is better, while the NPV approach will show differently.
The second disadvantage is, as said earlier, that it ignores cash flows after the cut-off date. Again lets use the example from Table 1.2 earlier and call it project X, and we ad another project called project Y. The cash outflows and inflows will be as the following:
Year
Project X (£)
Project Y (£)
0
– 100,000
– 100,000
1
20,000
35,000
2
40,000
30,000
3
25,000
35,000
Project Y paid back
4
15,000
–
Project X paid back
5
30,000
–
Not included in the payback method
Table 1.3
Here we can se that the payback for project Y is after 3 years, while project X still has 4. Now if a company was to follow all their investment decisions only based on the payback period method, it would chose project Y as it has the shortest payback period of 3 years. But if we add up all the cash inflows the company would get for the different projects, project Y would break even while project X will make a profit of £30,000. Therefor company has to use the payback period wisely so it doesn’t miss profitable projects where the cash inflows continue long after the cut-off date.
A third disadvantage with the PBP method is that it doesn’t consider time value of money. There is no discount rate for the inflows that occur in the later stages. Another method called ‘discounted payback period’ otherwise known as ‘net present value payback period’ can be used to solve that problem (efinancemanagement.com link). It basically just replaces the future cash flows with discounted cash flows and the rest of the calculation will remain the same.
