Reference no: EM13483783

This project costs $500. What is the payback period for this investment? The initial cost is $500. After the first two years, the cash flows total $300. After the third year, the total cash flow is $800, so the project pays back sometime between the end of Year 2 and the end of Year 3. Because the accumulated cash flows for the first two years are $300, we need to recover $200 in the third year. The third-year cash flow is $500, so we will have to wait $200/500 =.4 year to do this. The payback period is thus 2.4 years, or about two years and five months.

Summary of the Rule

To summarize, the payback period is a kind of "break-even" measure. Because time value is ignored, you can think of the payback period as the length of time it takes to break even in an accounting sense, but not in an economic sense. The biggest drawback to the payback period rule is that it doesn't ask the right question. The relevant issue is the impact an investment will have on the value of our stock, not how long it takes to recover the initial investment. Nevertheless, because it is so simple, companies often use it as a screen for dealing with the myriad of minor investment decisions they have to make. There is certainly nothing wrong with this practice. As with any simple rule of thumb, there will be some errors in using it, but it wouldn't have survived all this time if it weren't useful. Now that you understand the rule, you can be on the alert for those circumstances under which it might lead to problems. To help you remember, the following table lists the pros and cons of the payback period rule.

Advantages and Disadvantages of the Payback Period Rule
Advantages	Disadvantages
1. Easy to understand.	1. Ignores the time value of money.
2. Adjusts for uncertainty of later cash flows.	2. Requires an arbitrary cutoff point.
	3. Ignores cash flows beyond the Cut off date.
3. Biased towards liquidity.
	4. Biased against long-term projects, such as research and development, and new projects.

Questions:

a In words, what is the payback period? The payback period rule?

b Why do we say that the payback period is, in a sense, an accounting break-even measure?