Payback and Discounted Payback

Question 1

What is the Payback period?

Answer 1

The payback period is the number of years required to return the original investment; that is the time necessary for a new asset to pay for itself. Note that no accounting is made for the time value of money under this method

Companies using the payback method set a maximum length of time within which projects must pay for themselves to be considered acceptable

Payback period = Initial net investment / Annual expected cash flow

Question 2

What are strengths of the Payback method?

Answer 2

The strength of the payback method is its simplicity

The payback method is sometimes used for foreign investments if foreign expropriation of firm assets is feared. Even in these circumstances, it is most often used in addition to a more sophisticated method

To some extent, the payback period measures risk. The longer the period, the more risky the investment

Question 3

What are weaknesses of the Payback method?

Answer 3

The payback method has two significant weaknesses:

1. It disregards ALL cash inflows after the payback cutoff date. Applying a single cutoff date to every project results in accepting many marginal projects and rejecting good ones
2. It disregards the time value of money. Weighting all cash inflows equally ignores the fact that money has a cost

Question 4

What are advantages of the Discounted payback method?

Answer 4

The discounted payback method is sometimes used to overcome a major drawback inherent in the basic payback method (i.e. disregards the time value of money)

This is a more conservative technique than the traditional payback method

The discounted payback method’s advantage is that it acknowledges the time value of money

Question 5

What are disadvantages of the Discounted payback method?

Answer 5

Its drawbacks are that it loses the simplicity of the basic payback method and still ignores cash flows after the arbitrary cutoff date

Question 6

What is the Bailout payback method?

Answer 6

The bailout payback method incorporates the salvage value of the asset into the calculation

It measures the length of the payback period when the periodic cash inflows are combined with the salvage value

Question 7

What is the Payback reciprocal?

Answer 7

Payback reciprocal = 1 / Payback

This is sometimes used as an estimate of the internal rate of return

Question 8

What is Breakeven time?

Answer 8

The breakeven time is the period required for the discounted cumulative cash inflows on a project to equal the discounted cumulative cash outflows (usually but not always the initial cost)

Thus, it is the time necessary for the present value of the discounted cash flows to equal zero. This period begins at the outset of a project (NOT when the initial cash outflow occurs)

An alternative that results in a longer breakeven time is to consider the time required for the present value of the cumulative cash inflows to equal the present value of all expected future cash outflows