Payback period
The payback period technique asks the simple question: how long will it take for
the investment to pay for itself out of the cash inflows that it is expected to
generate?
Comparison of PBP and NPV methods
l The PBP method is badly flawed to the extent that it does not relate to the wealth
maximisation criterion: it is not concerned with increases in wealth. It promotes
the acceptance of shorter-term projects and thus promotes liquidity rather than
increased value.
l The PBP method takes account of the timing of the cash flows only in the most
perfunctory way. The method divides the life of the project into two portions: the
payback period and the period beyond it. PBP does not therefore treat cash flows
differently depending on when they arise. It merely puts any particular cash flow
into one of two categories: the relevant category and the irrelevant one. We can
see this incompleteness of consideration of the timing of cash flows by reference to
Example 4.1. With the Super, the PBP would be identical (four years) if there were
no savings in each of the first three years but a £25,000 saving in year 4. Clearly,
these two situations would not be regarded as equally desirable by any rational
investor, yet the PBP method is incapable of distinguishing between them. Some
businesses use a refinement of the PBP method that to some extent overcomes this
weakness. These businesses look at the discounted figures when assessing the payback period. Taking the discounted figures for the Zenith from page 84 we can see that the discounted payback period is 4 2926 3404 years (about 4.86 years), assuming that the cash flows occur evenly over the year; otherwise it is 5 years. The Super
does not have a discounted payback period, that is, its discounted inflows never
sum to its initial investment.
Not all relevant information is considered by the PBP method. The method
completely ignores anything that occurs beyond the payback period. For example,
the PBP method is incapable of discriminating between the anticipated cash flows
for the Super and those of some other project with identical outflows and inflows
until year 4 and then annual savings of £20,000 each year for the next ten years. This
point is also true of the discounted payback approach, outlined above.
The PBP method is very easy to use, and it will almost always give clear results.
How those results are interpreted is not so straightforward though. How does the
business decide what is the maximum acceptable payback period? Inevitably this is
a pretty arbitrary decision, which means that the PBP method itself will tend to lead
to arbitrary decision making, unless it is used for comparing competing projects
and the project with the shortest PBP is always selected. Even then it would promote quick returns rather than wealth maximisation.
Advocates of the PBP method argue that it will tend to identify the less risky projects, that is, those for which the investment is at risk for least time. Even so, the PBP
method takes a very limited view of risk. It only concerns itself with the risk that the
Accounting (unadjusted) rate of return 97
project will end prematurely. It ignores such risks as sales revenues being less than
anticipated or costs being greater than planned.
We may generally conclude that PBP is not a very good method for selecting
investment projects, and its use is likely to lead to sub-optimal decisions. It can,
however, give insights into projects that the NPV method fails to provide, particularly
on the question of liquidity. Thus the PBP method is seen by some as a useful complement to NPV.