Abstract
Despite the theoretical criticisms against it, payback is one of the most commonly used methods of investment appraisal in practice. Its ease of calculation and simplicity are seen as its most important advantages. In addition, an unsophisticated method like payback can yield the correct investment decision as long as the correct cut-off is specified. In this paper the optimum payback cut-off and how it is influenced by inflation is studied. Three different methods of calculating payback under inflation are investigated. In all of these the optimum cut-off depends upon the type of assets (current, depreciable or non-depreciable assets) as well as the life of depreciable assets employed. The study shows that the optimum nominal payback cut-off (where the payback calculation is based on inflated cash flows) decreases with increasing inflation for all asset types. The optimum real payback cut-off (based on nominal cash flows adjusted for inflation) does not change with inflation. The optimum uninflated payback cut-off (where inflation is ignored) decreases rapidly with inflation for projects employing current assets. In the paper is shown that complex but systematic relationships exist between a project's payback period and its discount rate. Despite its deficiencies, the use of the payback method is therefore not entirely irrational.
Highlights
It is generally accepted that the payback method of investment appraisal suffers from some serious deficiencies
A later survey of 58 American firms that operated in foreign countries found that 10 percent of firms use this as their primary decision criterion, while a further 62 percent use it as a secondary criterion (Oblak and Helm, 1980: 277)
In the United Kingdom, a survey undertaken for the Institute of Chartered Accountants in England and Wales found that 86 percent of respondents employ the payback method for investment appraisal (Westwick and Shohet, 1976: 10)
Summary
It is generally accepted that the payback method of investment appraisal suffers from some serious deficiencies. To determine the payback cut-off, one substitutes the proportion invested in each of the three asset types, the inflation rate and the appropriate nominal discount rate into equation (2) This yields the payback period of a marginal project. The effect of inflation on the optimal payback cut-off can be determined by assuming a constant real return and calculating the optimal payback cut-off for different inflation rates using equations (3) and (4) Pr = real payback period rR = real rate of return of the project (internal rate of return for cash flows expressed in real money terms) The optimum payback cut-off for single asset projects are calculated in Appendix 3.
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