The initial investment of $1.15 million is made sometime in the third year, leading to a payback of between two and three years. If we assume that cashflows occur uniformly over the course of the year:

Payback for Project = 2 + (395000/446500) = 2.88 years

Using Payback in Decision Making

While it is uncommon for firms to make investment decisions based solely on the payback, surveys suggest that some businesses do in fact use payback as their primary decision mechanism. In those situations where payback is used as the primary criterion for accepting or rejecting projects, a "maximum" acceptable payback period is typically set. Projects that pay back their initial investment sooner than this maximum are accepted, while projects that do not are rejected.

Firms are much more likely to employ payback as a secondary investment decision rule and use it either as a constraint in decision making (e.g.: Accept projects that earn a return on capital of at least 15%, as long as the payback is less than 10 years) or to choose between projects that score equally well on the primary decision rule (e.g.: when two mutually exclusive projects have similar returns on equity, choose the one with the lower payback.)

Biases, Limitations, and Caveats

The payback rule is a simple and intuitively appealing decision rule, but it does not use a significant proportion of the information that is available on a project. • By restricting itself to answering the question "When will this project make its initial investment?" it ignores what happens after the initial investment is recouped. This is a significant shortcoming when deciding between mutually exclusive projects. To provide a sense of the absurdities this can lead to, assume that you are picking between two mutually exclusive projects with the cash flows shown in Figure 5.2:

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