The payback period is both conceptually simple and easy to calculate. It is also a seriously flawed method of evaluating investments.
The payback period is the time taken to recover the initial investment. So a £1m investment that will make a profit of £200,000 a year has a payback period of five years. Investments with a shorter payback period are preferred to those with a long period. Most companies using payback period as a criterion will have a maximum acceptable period.
The payback period has a number of serious flaws:
- It attaches no value to cashflows after the end of the payback period.
- It makes no adjustments for risk.
- It is not directly related to wealth maximisation as NPV is.
- It ignores the time value of money.
- The "cut off" period is arbitrary.
To compensate for some of these deficiencies, one can adjust the cash flow by discounting the cashflow using the WACC and then calculating the payback period. This only really adjusts for the time value of money and it therefore does not address the other deficiencies of the payback period.
One justification for the use of the payback period is that it is conservative, as it values only short term returns which can be foreseen with reasonable certainty. However this argument does not really stand up to scrutiny; the NPV (or APV) also adjusts for the uncertainty of future cashflows and does so correctly.
One explanation of the wide use of the payback period is that as a conservative criterion it is preferred by managers who have an undiversifiable stake in a company (i.e. their jobs), This makes it preferable to less conservative criteria that might be preferred by shareholders who can diversify.