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A WORD OF CAUTION

Some people confuse the internal rate of return on a project with the opportunity cost of capital. Remember that the project IRR measures the profitability of the project. It is an internal rate of return in the sense that it depends only on the project s own cash flows. The opportunity cost of capital is the standard for deciding whether to accept the project. It is equal to the return offered by equivalent-risk investments in the capital market.

PAYBACK

These days almost all large companies use discounted cash flow in some form, but sometimes they use it in combination with other theoretically inappropriate measures of performance. We next examine two of these measures, the payback period and the book rate of return.

We suspect that you have often heard conversations that go something like this: A washing machine costs about $400. But we are currently spending $3 a week, or around $150 a year, at the laundromat. So the washing machine should pay for itself in less than 3 years. You have just encountered the payback rule.

A project s payback period is the length of time before you recover your initial investment. For the washing machine the payback period was just under 3 years. The payback rule states that a project should be accepted if its payback period is less than a specified cutoff period. For example, if the cutoff period is 4 years, the washing machine makes the grade; if the cutoff is 2 years, it doesn t.

As a rough rule of thumb the payback rule may be adequate, but it is easy to see that it can lead to nonsensical decisions. For example, compare projects A and B. Project A has a 2-year payback and a large positive NPV. Project B also has a 2-year payback but a negative NPV. Project A is clearly superior, but the payback rule ranks both equally.

This is because payback does not consider any cash flows that arrive after the payback period. A firm that uses the payback criterion with a cutoff of two or more years would accept both A and B despite the fact that only A would increase shareholder wealth.

A second problem with payback is that it gives equal weight to all cash flows arriving before the cutoff period, despite the fact that the more distant flows are less valuable. For example, look at project C. It also has a payback period of 2 years but it has an even lower NPV than project B. Why? Because its cash flows arrive later within the payback period.

To use the payback rule a firm has to decide on an appropriate cutoff period. If it uses the same cutoff regardless of project life, it will tend to accept too many short-lived projects and reject too many long-lived ones. The payback rule will bias the firm against accepting long-term projects because cash flows that arrive after the payback period are ignored.

Earlier we evaluated the Channel Tunnel project. Large construction projects of this kind inevitably have long payback periods. The cash flows that we presented in Table 4.1 implied a payback period of just over 14 years. But most firms that employ the payback rule use a much shorter cutoff period than this. If they used the payback rule mechanically, long-lived projects like the Channel Tunnel wouldn t have a chance.

The primary attraction of the payback criterion is its simplicity. But remember that the hard part of project evaluation is forecasting the cash flows, not doing the arithmetic. Today s spreadsheets make discounting a trivial exercise. Therefore, the payback rule saves you only the easy part of the analysis.5

We have had little good to say about payback. So why do many large companies continue to use it? Senior managers don t truly believe that all cash flows after the payback period are irrelevant. It seems more likely (and more charitable to those managers) that payback survives because the deficiencies are relatively unimportant or because there are some offsetting benefits. Thus managers may point out that payback is the simplest way to communicate an idea of project desirability. Investment decisions require discussion and negotiation between people from all parts of the firm and it is important to have a measure that everyone can understand. Perhaps also managers favor quick payback projects even when they have lower NPVs, because they believe that quicker profits mean quicker promotion. That takes us back where we discussed the need to align the objectives of managers with those of the shareholders.

In practice payback is most commonly used when the capital investment is small or when the merits of the project are so obvious that more formal analysis is unnecessary. For example, if a project is expected to produce constant cash flows for 10 years and the payback period is only 2 years, the project in all likelihood has a positive NPV.

5 Sometimes managers calculate the discounted payback period. This is the number of periods before the present value of prospective cash flows equals or exceeds the initial investment. Therefore, this rule asks, How long must the project last in order to offer a positive net present value? This surmounts the objection that equal weight is given to all cash flows before the cutoff date. However, the discounted payback rule still takes no account of any cash flows after the cutoff date.

The discounted payback does offer one important advantage over the normal payback criterion. If a project meets a discounted payback cutoff, it must have a positive NPV, because the cash flows that accrue up to the discounted payback period are (by definition) just sufficient to provide a present value equal to the initial investment. Any cash flows that come after that date tip the balance and ensure positive NPV.

Despite this advantage, the discounted payback has little to recommend it. It still ignores all cash flows occurring after the arbitrary cutoff date and therefore will incorrectly reject some positive NPV opportunities. It is no easier to use than the NPV rule, because it requires determination of both project cash flows and an appropriate discount rate. The best that can be said about it is that it is a better criterion than the even more unsatisfactory ordinary payback rule.

PAYBACK PERIOD Time until cash flows recover the initial investment of the project.