1.9 Payback and Discounted Payback Summary
The following summarizes some critical issues relative to the use of Payback and Discounted Payback methods.
- Either method provides the analyst with a preference or ranking system. Clearly one would prefer a shorter payback to a longer payback; a four-year payback is preferred to a five-year payback.
- Neither method provides you with a clear rule of thumb, i.e., a clear decision rule, by which one can assess whether to categorically accept or reject a project. Saying merely that the payback is “four years” alone is insufficient. Given an independent project, what would you do?
- The simple payback method is inconsistent with the time value of money. A serious implication of this shortcoming may be illustrated by two competing projects both of which have the same paybacks. If one project has relatively larger cash flows coming in sooner, its discounted payback may be shorter than the other’s discounted payback.
- Neither method considers any cash flows that may come in subsequent to the payback. A project may be rejected due to its longer payback; however, it may have relatively larger cash flows coming in subsequent to the payback, which are ignored by methodology.
- We have assumed that the inputted Free Cash Flow (“FCF”) projections are certain, which they are unlikely to be. This text will not deal with “Capital Budgeting Under Uncertainty” methods.
- Neither method provides a Rate of Return, which most interests Financial Analysts.