In this lesson, we’ll learn about the (discounted) payback period rule, which is a popular capital budgeting tool that helps corporate managers make investment decisions. We’ll discuss the pros and cons of this rule vis-à-vis the net present value (NPV) rule and will offer a (discounted) payback period calculator as well.
Contents
What is the “payback period rule”?
Imagine that you have an investment opportunity that will cost you $100,000 to invest. The project will generate regular annual cash flows starting from the year after your investment. In this case, the payback period is the time it would take for you to recoup your original investment of $100,000.
For example, if the project generates $40,000 each year, it would take less than 3 years for you be paid back, since 3 × $40,000 > $100,000. To be precise, the payback period in such a case would be:
2 + ($100,000 − $80,000)/$40,000 = 2.5
In other words, it takes 2 years to get back $80,000 and the remaining $20,000 is paid back in half a year, hence 2.5 years in total. You should then decide whether this is quick enough for you. For example, if your rule is to accept projects that pay back within 3 years, this is a good project for you to invest in. But, if you want to be paid back within 2 years, then you should forgo this project.
This is a very practical rule that gives managers an idea about how long it would take for them to break even on their investments. There are several drawbacks, however. To begin with, unlike the NPV rule, the time value of money is ignored. Specifically, there is an opportunity cost of tying your funds ($100,000 in this case) to a specific project. By doing so, you lose the opportunity to invest in alternative projects (the simplest one would be to deposit the funds in a bank and earn interest).
The discounted payback period is developed to address this shortcoming as it is based on the present values of future cash flows. If we assume a discount rate of 10%, in our example the remaining balance after two years would be:
$100,000 − $40,000 / 1.1 − $40,000 / 1.12 = $30,578.51
And, the discounted payback period would be:
2 + ($30,578.51)/$40,000 = 2.76
which is, of course, longer than our original answer of 2.5 years (see Figure 1 below).
There are further drawbacks to consider. First, there is no objective answer to what should be the cutoff duration when employing these rules. Two years? Five years? Ultimately, this becomes a subjective choice, and even a particular manager can adopt different cutoff durations at different points in time.
Second, neither the regular nor the discounted version of this tool considers cash flows beyond the payback period. This is really problematic. Consider the following two projects.
| Year | Project A | Project B |
|---|---|---|
| 0 | −$20,000 | −$20,000 |
| 1 | $20,000 | $15,000 |
| 2 | $20,000 | $30,000 |
| 3 | $20,000 | $60,000 |
| 4 | $20,000 | $120,000 |
With Project A, we recover our investment in 1 year. With Project B, it is 1.17 years. So, according to the payback rule, we should prefer Project A over Project B. But, look at the cash flows from year 2 onwards. Project B is really dominating Project A, and it would be foolish to invest in the latter at the expense of the former. In fact, even at a pretty high discount rate of 50%, Project B’s NPV is well above that of Project A:
At 50%: NPVB = $44,815 > NPVA = $12,099
For these reasons, finance textbooks emphasize the use of the NPV rule, which considers not only the time value of money but also all cash flows of a project. As a result, while the (discounted) payback period rule is a practical tool that can support decision making, we can’t solely rely on that for capital budgeting purposes.
Test your knowledge
Lindsay has an opportunity to invest in a project that costs $10,000. The project yields the following cash flows. The discount rate is 20%. If Lindsay wants to recover her investment within 4 years, should she invest in this project?
Note: You can use the calculator below. The solution is provided at the bottom of this page.
| Year | Cash flow |
|---|---|
| 1 | $2,000 |
| 2 | $3,000 |
| 3 | $4,000 |
| 4 | $5,000 |
| 5 | $6,000 |
| 6 | $7,000 |
Payback period calculator
Please note the following instructions when using the calculator:
- Enter the investment cost with a negative sign. For example, if the project costs $5,000 to invest, enter −5000.
- Enter the discount rate as a percentage point. For example, if it is 8%, enter 8.
- You can check the solution for the “test your knowledge” exercise below to see an example use of this calculator.
Video tutorial
What is next?
You might find the following posts useful as well:
Further reading:
Graham J R, Harvey C R, (2001) “The theory and practice of corporate finance: evidence from the field“, Journal of Financial Economics, Volume 60 (2–3), pp. 187-243.
Solution for the “test your knowledge” exercise
Using the payback period calculator above, we find that this project’s payback period is 3.2 years and its discounted payback period is 4.632 years (see Figure 2 below). Given that Lindsay wants to be paid back within 4 years, she would be better off skipping this project as the discounted payback period, which considers the time value of money, is longer than 4 years.
