Table

Investment Projected Cash Flows

Now we have a problem. The NPV of the shorter-term investment is actually negative, meaning that taking it diminishes the value of the shareholders' equity. The opposite is true for the longer-term investment—it increases share value.

Our example illustrates two primary shortcomings of the payback period rule. First, by ignoring time value, we may be led to take investments (like Short) that actually are worth less than they cost. Second, by ignoring cash flows beyond the cutoff, we may be led to reject profitable long-term investments (like Long). More generally, using a payback period rule will tend to bias us towards shorter-term investments.

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