Introduction to Corporate Finance

PART 3: CAPITAL BUDGETING

rule. Particularly in large companies, managers rotate quite often from one job to another. To obtain

promotions and to enhance their reputations, managers want to make investments that will enable them

to point to success stories at each stage of their careers. A manager who expects to stay in a particular

position in a company for just two or three years may prefer to undertake investments that recover costs

quickly, rather than projects that have payoffs far into the future.

Arguments Against the Payback Method

Although the payback method has apparent virtues, it also suffers from some serious problems. The payback

cutoff period is simply a judgement with no direct connection to share value maximisation. How can we be

sure that accepting projects that pay back within three years will maximise shareholder wealth? What if a

project has an enormous payoff in year 4 or year 5? Payback ignores cash flows beyond the cutoff point.

The way that the payback method accounts for the time value of money is crude. The payback method

assigns a 0% discount rate to cash flows that occur before the cutoff point. That is, if the payback period is

three years, then cash flows that occur in years 1, 2 and 3 receive equal weight in the payback calculation.

Beyond the cutoff point, the payback method ignores all cash flows. In other words, cash flows in year 4 and

beyond receive zero weight (or have zero present value), as if the discount rate were infinite.

What happens if the project has an early payoff followed by negative cash flows after the payback

period? The payback method does not adjust for these situations.

The career concerns of managers, which may lead them to prefer the payback rule, could also be an

argument against the payback method. Managers might simply choose investments with rapid payback

periods in order to gain early recognition of their successes and progress their careers; but these options

may not be in the best long-term interests of shareholders. This is a classic principal–agent problem, where

the interests of the agents looking after the company (i.e. the managers) are not completely aligned with the

interests of the principals (i.e. the shareholders who have appointed the managers to act on their behalf).

9-2c DISCOUNTED PAYBACK

The discounted payback period is the same as the payback period, except that in calculating the former,

managers discount cash flows first. In other words, the discounted payback method calculates how long

it takes for a project’s discounted cash flows to recover the initial investment. This represents a minor

improvement over the simple payback method, in that it does a better job of accounting for the time value

of cash flows that occur within the payback cutoff period. As with the ordinary payback rule, discounted

payback totally ignores cash flows that occur beyond the cutoff point, and the chosen cutoff is often

arbitrary. Thus, this method also suffers from many of the problems associated with the payback method.

example

Suppose that Global Untethered uses the discounted payback method, with a discount rate of 18% and a

cutoff period of three years. The following schedules show the present value (PV) of each project’s cash flows

during the first three years.^2 For example, $29.7 million is the present value of the $35 million that the Western

Europe investment is expected to earn in its first year, $57.5 million is the present value of the $80 million that

the project is expected to earn in its second year, and so on.

2 We are assuming here that the first year’s cash flows occur one year after the initial investment (end of year 1), the second year’s cash flows

occur two years after the initial investment (end of year 2), and so on.

discounted payback

period

The amount of time it takes

for a project’s discounted cash

flows to recover the initial

investment

Daniel Carter, Vice

President of Finance,

BevMo!

‘It’s a metric that,

frankly, most of our

operators can truly

appreciate.’

See the entire interview on

the CourseMate website.

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Source: Cengage Learning