The Payback Rule - Recovering Initial Investment Costs

As the heading suggests, the Payback Rule is the amount of time it takes for you to recover the initial cost of an investment that you are undertaking. Therefore, an investment is acceptable if the Payback that results from it falls under a pre-determined # of years. An example would illustrate this well:

|0__________|1_________|2_________|3_______|4_________|

-$50,000

$30,000

$20,000

$10,000

$5,000

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This is a financial timeline with cash flows of $50,000 (initial investment), 30 thousand in Year 1, 20 thousand in Year 2, 10 thousand in Year 3 and 5000 in Year 4.

What is the payback period in this case? Well the company initially invests $50,000 and recovers $30,000 of it in the 1st year. This means it has $20,000 more left to recover (50,000 - 30,000). In the 2nd year, the company has a cash flow of $20,000 and this is the point where the company BREAK EVENS. Thus, the Payback Period is exactly 2 years.

In most instances, the numbers and cash flows won't be as good as in the above example. We would have to work with fractions, as in this next question:

The Payback Rule Question

The following company invests $10,000 initially into a corner store investment. The cash flows from Years 1-6 are provided in the table. What is the Payback Period?

	Cash Flows	Cumulative Cash Flows
Initial Investment	-$10,000	$-10,000
Year 1	1500	-8500
Year 2	2500	-6000
Year 3	4000	-2000
Year 4	3000	+1000
Year 5	3000	+4000
Year 6	3000	+7000

Take a close look at the column of Cumulative Cash Flows. For Year 1, we subtract $10,000 - 1500 = -$8500

In Year 2, we subtract -$8500 + 2500 = -$6000

In Year 3, we subtract -$6000 + 4000 = -$2000

In Year 4, we subtract -2000 + $3000 = +$1000

The Payback Period occurs in Year 3, when the cash flow turns from a Negative (-2000) to a Positive (+1000). This is always true for any cash flow analysis you do. As soon as the cumulative cash flows turns from a negative to positive, that's your payback period.

Thus, Payback Period = 3 years + $2000 / $3000 = 3.67 Years

Therefore, in 3.67 years, we will recover all the $10,000 initial investment that we put down. That's why this term is called "payback", it will take this investment 3.67 years to pay us back.

Limitations & Disadvantages of using the Payback Period Rule

1) The Payback Period does not take into account time value of money. Since we are just adding up the future cash flows e.g $2500 in Year 2, $3000 in Year 3, etc, we are not discounting these payments and adjusting them for time value of money.

2) How sure are we that in Year 2, the investment will generate $2500? It is just an estimate. And as we know, the economy can be very volatile. Thus, the Payback Period rule does not take into account the risk of projected future cash flows.

3) Since we determine a cut-off point (3.67 years in the above example), we are ignoring the possibility of growing cash flows thereafter. An investment may not seem very attractive if we just select a cut-off point and we can ignore long term investments. Example, who knows that in the example above and in Year 7, we might have a Cash Flow of $6000? This would make it a very desirable LONG TERM investment, but financial managers may not come to realize this (because they cut-off at 3.67 years).