7-Payback_period

7) Payback period

The payback period is calculated as the number of years (or fraction of a year), that it takes to get back in cash flows the initial outlay put into a project. The method is to choose all projects whose payback period is less that a given payback cut-off, and when comparing projects, choose those that have the shortest payback periods.

For example: A mining company discovered a significant reserve of a precious metal. The potential mine is located in a politically unstable country where other mining companies have been reluctant to enter because of periodic social strife and likelihood of foreign business expropriation within two years if profitable. The initial investment is $ 5 millions, and net after tax incremental cash flows are estimated at $ 1, 2, 2, 5 and 8 millions over the next five years.

Solution: the payback period PBP is 3 years since it takes the cash flows of the first three years (i.e. 1+2+2) to cover the initial investment of $ 5 millions. But the potential of expropriation within 2 year is the payback cut-off. The payback period of the project is longer than the payback cut-off. The project should be rejected.

The method is fundamentally defective because it ignores cash flows beyond the payback period (which would the additional wealth for the owner). The lack of discounting is also theoretically questionable. But, as the example illustrates, in all situations where an external threat may have an overwhelming influence, these drawbacks are minor, and the method has its usefulness.

Recently, a discounted payback method has started to appear in finance textbooks. It is calculated as the number of years it takes for the discounted cash flow sum to be equal to the initial outlay. When studying duration of bonds in Chapter 4 Section D-1, one will recognize that the two concepts are identical.

See review questions Q-3G7.1 through Q-3G7.4.

See research assignment R-3.21.

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