Thursday, May 31, 2012

Capital Budgeting Part 3: The Payback Period Rule


In Part 2, I discussed the net present value (NPV) rule for capital budgeting. While this method is the most fundamentally sound and most widely used capital budgeting decision criteria available, there's another rule that smaller businesses favor more because it's simpler to use and understand: the payback period rule.

The concept is probably not new to you, although like some people I know you might have mistakenly referred to it as "return on investment," which is a different thing altogether. The payback period rule asks a simple question: how soon will you be able to recover your investment? If the answer is "soon enough," then invest in the project or buy the asset in question; if not, then don't.

For example, if you estimate that a particular project, which costs 4 million pesos, will generate after-tax cash flows of 1 million per year in the next five years, then its payback period--the number of years it will take to recover your initial investment--is four years. That in itself does not lead to a decision; you would have to ask yourself whether, for whatever reason, that payback period is acceptable to you.

It's easy to see why small businesses and many individuals prefer using this method over the NPV rule. First, it's easier to use since there is no need to estimate the cost of capital (the discount rate used to get the present value of cash flows) and it involves infinitely less complicated computations. And second, it just seems to make sense that the shorter the payback period, the more "liquid"--and thus more attractive--the project is.

Unfortunately, like my favorite toy line there's more than meets the eye to the payback period rule--there is a reason why bigger and more sophisticated financial managers use NPV instead. First, unlike NPV, the payback period rule does not consider the riskiness of cash flows and the time value of money. Second, the payback period rule ignores cash flows beyond the payback period (such as the last million in year five of the example). These limitations are crucial because they could lead to the acceptance of negative-NPV or value-losing projects, and vice versa.

Therefore, despite its simplicity, the payback period rule should not be used as a stand-alone capital budgeting criteria. At most, use this method only to roughly gauge the attractiveness of investment prospects, before the cost of capital can be estimated and used for NPV analysis.

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