Chapter 4 • Investment appraisal methods
The decision rule for the PBP method is that projects will be selected only if they
pay for themselves within a predetermined period. Competing projects would be
assessed by selecting the one with the shorter PBP (provided it was within the pre-
determined maximum). Thus PBP favours the Zenith over the Super (if cash flows
are assumed to occur evenly).Comparison of PBP and NPV methods
l The PBP method is badly flawed to the extent that it does notrelate to the wealth
maximisation criterion: it is not concerned with increases in wealth. It promotes
the acceptance of shorter-term projects and thus promotes liquidity rather than
increased value.
l The PBP method takes account of the timing of the cash flows only in the most
perfunctory way. The method divides the life of the project into two portions: the
payback period and the period beyond it. PBP does not therefore treat cash flows
differently depending on when they arise. It merely puts any particular cash flow
into one of two categories: the relevant category and the irrelevant one. We can
see this incompleteness of consideration of the timing of cash flows by reference to
Example 4.1. With the Super, the PBP would be identical (four years) if there were
no savings in each of the first three years but a £25,000 saving in year 4. Clearly,
these two situations would not be regarded as equally desirable by any rational
investor, yet the PBP method is incapable of distinguishing between them. Some
businesses use a refinement of the PBP method that to some extent overcomes this
weakness. These businesses look at the discounted figures when assessing the pay-
back period. Taking the discounted figures for the Zenith from page 84 we can
see that the discounted payback period is 4–––^29263404 years (about 4.86 years), assuming
that the cash flows occur evenly over the year; otherwise it is 5 years. The Super
does not have a discounted payback period, that is, its discounted inflows never
sum to its initial investment.
l Not all relevant information is considered by the PBP method. The method
completely ignores anything that occurs beyond the payback period. For example,
the PBP method is incapable of discriminating between the anticipated cash flows
for the Super and those of some other project with identical outflows and inflows
until year 4 and then annual savings of £20,000 each year for the next ten years. This
point is also true of the discounted payback approach, outlined above.
l The PBP method is very easy to use, and it will almost always give clear results.
How those results are interpreted is not so straightforward though. How does the
business decide what is the maximum acceptable payback period? Inevitably this is
a pretty arbitrary decision, which means that the PBP method itself will tend to lead
to arbitrary decision making, unless it is used for comparing competing projects
and the project with the shortest PBP is always selected. Even then it would pro-
mote quick returns rather than wealth maximisation.Advocates of the PBP method argue that it will tend to identify the less risky pro-
jects, that is, those for which the investment is at risk for least time. Even so, the PBP
method takes a very limited view of risk. It only concerns itself with the risk that the