Developments of the payback method

Abstract

In spite of its theoretical deficiencies, the payback (PB) method is commonly used for appraisals of capital investments in companies. Sometimes the method is used when aspects such as liquidity and project time risk are focused, but it is also commonly used in pure profit evaluations as a single criterion. The two main deficiencies of the PB method are that it does not measure the time value of money in a correct manner and that it ignores cash flows after the payback period (PP). These deficiencies can be reduced if the maximum acceptable PP is chosen in a somewhat more sophisticated way. In practice the maximum acceptable PP is often chosen as a fixed value, e.g., three years. In some cases the limit value of the PP has been related to the economic life of the investment, e.g., a PP shorter than half the economic life. If these two rules of thumb are combined, a more theoretically correct evaluation of investments can be achieved. Such a combined PB method is based on the assumption of constant yearly cash flows. However, the method can be developed to handle cases with varying cash flows, but then some of its simplicity is lost. Due to the fact that the decision situations in the evaluation of capital investments typically are uncertain concerning the time pattern and the duration of the cash flows, this can justify the use of a simple but more robust PB method even if there would be time for more advanced analyses.