methods come to the same conclusion. The IRR ignores the relative sizes of alternative
projects and is not always a single unique value.Payback Period (PP)
The payback period, PP, is the length of time it takes to recover the initial investment of
the project. To apply the payback period criterion, it is necessary for management to
establish a maximum acceptable payback value PP. In practice, PP is usually between
2 and 4 years.
The decision rule in determining whether to accept or reject a particular project using
the payback period is:
Accept if PP < PP*
Reject if PP > PP*For mutually exclusive alternatives accept the project with the lowest PP if PP<PP*
It appears that the payback method is not consistent with the goal of shareholder wealth
maximization.The problems with the payback method are that:
It ignores the time value of money
It ignores the cash flows that occur after the payback period; and,
It ignores the scale of investment.Payback Period: accounting for money at risk
One of the attractions of the payback period is that it provides some measure of the
"money at risk". At the start of the project we are presented with a lot of uncertainty
about future cash flows, and the economic environment and our cash flows may turn out
more or less favourable than we initially anticipated, with uncertainty being larger for
those cash flows in the more distant future.
However, the payback criterion is the wrong method to account for that. In analyzing the
risk associated with cash flows that are more distant, there are two tools used. The first
concerns the setting of discount rates. We shall see later that discount rates can be