Project A

Investment $ 1000

Payback = 3 years Project B

Investment $ 1000

Payback = 2 years

On the basis of the payback alone, project B is preferable to project A, since it has a shorter payback period. Most decision makers would pick project A as the better project, however, because of the high cash flows that result after the initial investment is paid back.

• The payback rule is designed to cover the conventional project that involves a large up-front investment followed by positive operating cash flows. It breaks down, however, when the investment is spread over time or when there is no initial investment.

• The payback rule uses nominal cash flows and counts cash flows in the early years the same as cash flows in the later years. Since money has time value, however, recouping the nominal initial investment does not make the business whole again, since that amount could have been invested elsewhere and earned a significant return.

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