Net present value and other investment criteria

The Payback Rule

The payback period is the amount of time required for an investment to generate cash flows sufficient to
recover its initial cost. This investment pays for itself back in exactly two year OR payback period is two
years.

 “An investment is acceptable if its calculated payback period is less than some specified number of
years.”

Suppose the initial investment is $60,000, and the cash flows are $20,000 in the first year and $90,000 in
the second.

 The cash flows over the first two years are $110,000, so the project pays back sometime in the second
year.

 After the first year, the project has paid back $20,000, leaving $40,000 to be recovered

 Note that this $40,000 is $40,000/90,000 = 4/9 of the second year’s cash flows.

 Spreading this ratio over 365 days:

4/9 x 365 = 162 days (approx.)

This means, that the payback period is just over 1 year and 5 months

Payback rule

The payback period for a project is the initial fixed investment in the project divided by the estimated
annual net cash inflows from the project. The ratio of these quantities is the number of years required for
the project to repay its initial fixed investment. For example, assume a project costs $100,000 to
implement and has annual net cash inflows of $25,000.

Payback Period = $100,000/$25,000 = 4 years

Then This method assumes that the cash inflows will persist at least long enough to pay back the
investment, and it ignores any cash inflows beyond the payback period. The method also serves as an
(inadequate) proxy for risk. The faster the investment is recovered, the less the risk to which the firm is
exposed.

Year Long Short

project project
0 -$250 -$250
1 $100 $100
2 $100 $200
3 $100 0
4 $100 0
The payback on long is

2 + $50/100 = 2.5 years

The payback on short is

1 + $150/200 = 1.75 years

 With a cutoff of two years, short is accepted and long is not

 Is payback period rule giving us the right decisions?

 Suppose, we require a 15% return on this kind of investment; NPV for the two investments is:

NPV (Short) = -$250 +100/1.15 + 200/1.152 = -$11.81

NPV (Long) = -$250 + 100 x (1 – 1/1.154 )/.15 = $35.5

We can see that the NPV of shorter term investment is negative, which would diminish the
value of shareholders’ equity.

 Longer term investment increases share value.

Summary

 A break-even measure; in accounting sense but not in economic sense.

 Does not focus on right issue of impact of investment on value of stock.

 Simplicity helpful for decisions on minor investments.

Advantages

 Easy to understand

 Adjusts for uncertainty of later cash flows

 Biased towards liquidity

Disadvantages

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