Summary of the Rule

To summarize, the payback period is a kind of "break-even" measure. Because time value is ignored, you can think of the payback period as the length of time it takes to

Ross et al.: Fundamentals I IV. Capital Budgeting I 9. Net Present Value and I I © The McGraw-Hill of Corporate Finance, Sixth Other Investment Criteria Companies, 2002

Edition, Alternate Edition

282 PART FOUR Capital Budgeting break even in an accounting sense, but not in an economic sense. The biggest drawback to the payback period rule is that it doesn't ask the right question. The relevant issue is the impact an investment will have on the value of our stock, not how long it takes to recover the initial investment.

Nevertheless, because it is so simple, companies often use it as a screen for dealing with the myriad of minor investment decisions they have to make. There is certainly nothing wrong with this practice. As with any simple rule of thumb, there will be some errors in using it, but it wouldn't have survived all this time if it weren't useful. Now that you understand the rule, you can be on the alert for those circumstances under which it might lead to problems. To help you remember, the following table lists the pros and cons of the payback period rule.

Advantages and Disadvantages of the Payback Period Rule



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