What is Payback Period ?

We have earlier discussed the fact that Net present Value (NPV) is considered to be the gold standard when it comes to financial decision making. If a project has an NPV greater than zero then it is supposed to be a financially viable project and the firm must invest its resources towards that project, if not the project should be rejected.

But NPV is not the only metric that we can use to come to this decision regarding accepting or rejecting a project. Payback period is another such metric. In this article we will discuss about the conceptual foundation of payback period and then we shall see its drawbacks.

Payback Period

Payback period basically pays attention to the speed at which the initial investment made in a project will be recovered by subsequent cash flows. The project which helps recoup the investment the fastest is considered to be the best project and that is the project that the firm must dedicate its resources to.

Example:

Let’s say that there are 2 projects A and B. Both require an equal outlay of $2000. Project A pays back $1500 in year 1, $500 in year 2 and $500 in year 3. Project B on the other hand pays $750 for 4 consecutive years.

So, now in this case if we were to use the payback period rule. We could consider the period in which the initial $2000 investment is recovered. In case of Project A, we recover it in 2 years whereas in case of Project B it requires 3 years. So according to the payback rule, Project A is better than Project B and the company must clearly devote its finite resources to Project A before it decides whether or not to undertake Project B.

Now, this decision could be wrong because of a couple of reasons:

1. Firstly, we are only calculating the time it requires to recoup the initial investment we made. In doing so, we are disregarding all the cash flows that occur after the initial investment has been fully recouped. In the above example, Project A pays out a total of $2500, whereas Project B pays out a total of $3000 over its lifetime. Yet, our decision criteria made us disregard this and choose Project A. So using payback period as your decision criteria could lead you to disregard projects that pay slower but would in fact pay more and therefore add more value to the firm.

2. Secondly, the money value of all the cash flows happening in all of the years was considered to be the same. This means that we are implicitly saying that the value of a dollar received in year 1 is the same as the value received in year 4 or 5. We know this is not the case. The real value of the money keeps on declining as time passes. Besides, we also ignore the opportunity cost of the money that we could have earned if we received the cash earlier.

To overcome the second limitation of ignoring the time value of money, a modified measure of payback period called the discounted payback period is often used. This measure still does not overcome the fact that payback period does not account for the cash flows after the initial investment has been recouped. This is the reason why payback period is not a perfect metric and why NPV leads to better decisions.

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