9: Capital Budgeting Process and Decision CriteriaexampleThe investment to expand the mobile network
in Western Europe requires an initial outlay of
$250 million. According to the company’s cash
flow projections, this project will bring $245
million in its first three years ($35 million in year
1 + $80 million in year 2 + $130 million in year 3)
and $405 million after four years ($245 million in
the first 3 years + $160 million in year 4). So the
company will fully recover its $250 million initial
outlay sometime during year 4. Because the
company only needs to recover $5 million ($250
million initial outlay – $245 million recovered in
the first 3 years) in year 4, assuming cash flow
occurs at a constant rate throughout the year,
we can estimate the fraction of year 4 as 0.03,
by dividing the $5 million that needs to be
recovered in year 4 by the $160 million expected
to be recovered in that year. The payback period
for Western Europe is therefore 3.03 years; so
Global Untethered would reject the investment,
because this payback period is longer than the
company’s maximum three-year payback period.
The toehold investment in the South-eastern
Australia project requires just $50 million. In its first
two years, this investment generates $40 million in
cash flow ($18 million in year 1 + $22 million in year
2). By the end of year 3, it produces a cumulative
cash flow of $65 million ($40 million in the first 2
years + $25 million in year 3). Thus, the project earns
back the initial $50 million at some point during year- It needs to recover $10 million ($50 million initial
outlay – $40 million recovered in the first 2 years)
in year 3. We can estimate the fraction of year 3 as
0.40, by dividing the $10 million that needs to be
recovered in year 3 by the $25 million expected to
be recovered that year. The payback for the South-
eastern Australian project is therefore 2.40 years.
Global Untethered would undertake the investment
because this payback period is shorter than the
company’s maximum three-year payback period.
9-2b PROS AND CONS OF THE PAYBACK METHOD
Arguments in Favour of the Payback Method
Simplicity is payback’s main virtue. Once a company estimates a project’s cash flows, it is simply a matter of
addition to determine when the cumulative net cash inflows will equal the initial outlay. The intuitive appeal
of the payback method is strong. It sounds reasonable to expect a good investment to pay for itself in a fairly
short time. Indeed, the time value of money suggests that, other things being equal, a project that brings
in cash flow faster ought to be more valuable than one with more distant cash flows. Small companies,
which typically operate with limited financing, tend to favour payback because it is simple and because
receiving more cash flow sooner allows them more financial flexibility. Some managers say that establishing
a short payback period is one way to account for a project’s risk exposure. They argue that projects that
take longer to pay off are intrinsically riskier than those that recoup the initial investment more quickly,
partly because forecast errors tend to increase with the length of the payback time period. The payback
period is a popular decision-making technique in highly uncertain situations, where it is frequently used as
the primary technique. It is used frequently for international investments made in unstable economic and
political environments and in risky domestic investments, such as oil drilling, and new business ventures.
Another justification given for using the payback method is that some companies face financing
constraints. Advocates of the payback method argue that it makes sense for cash-strapped companies to
use payback because it indicates how quickly the company can generate cash flow to repay debt or to
pursue other investment opportunities. Career concerns may also lead managers to prefer the payback