Redeeming Qualities of the Rule

Despite its shortcomings, the payback period rule is often used by large and sophisticated companies when they are making relatively minor decisions. There are several reasons for this. The primary reason is that many decisions simply do not warrant detailed analysis because the cost of the analysis would exceed the possible loss from a mistake. As a practical matter, it can be said that an investment that pays back rapidly and has benefits extending beyond the cutoff period probably has a positive NPV.

Small investment decisions are made by the hundreds every day in large organizations. Moreover, they are made at all levels. As a result, it would not be uncommon for a corporation to require, for example, a two-year payback on all investments of less than $10,000. Investments larger than this would be subjected to greater scrutiny. The requirement of a two-year payback is not perfect for reasons we have seen, but it does exercise some control over expenditures and thus has the effect of limiting possible losses.

In addition to its simplicity, the payback rule has two other positive features. First, because it is biased towards short-term projects, it is biased towards liquidity. In other words, a payback rule tends to favor investments that free up cash for other uses more quickly. This could be very important for a small business; it would be less so for a large corporation. Second, the cash flows that are expected to occur later in a project's life are probably more uncertain. Arguably, a payback period rule adjusts for the extra riskiness of later cash flows, but it does so in a rather draconian fashion—by ignoring them altogether.

We should note here that some of the apparent simplicity of the payback rule is an illusion. The reason is that we still must come up with the cash flows first, and, as we discussed earlier, this is not at all easy to do. Thus, it would probably be more accurate to say that the concept of a payback period is both intuitive and easy to understand.

0 0

Post a comment