Appendix A 233Calculation Approach:
PBP = the smallermsuch that AΣ t≥C 0
t = 1mDecision Rule: If PBP is less than or equal to a predetermined limit (often
called a hurdle rate), then the investment is attractive.
Important Note: This form of payback period ignores the time value of
money and ignores returns beyond the predetermined limit.
The fact that this approach ignores time value of money concepts is
apparent by the fact that no time value of money factors are included in
the determination of m. This implicitly assumes that the applicable inter-
est rate to convert future amounts to present amounts is zero. This implies
that people are indifferent between $100 today and $100 one year from
today, which is an implication that is highly inconsistent with observable
behavior.
The short-term focus of the payback period measure of worth can
be illustrated using the cash flow diagrams of Figure A-8. Applying the
PBP approach above yields a payback period for investment (a) of PBP =
2 (1200>1000 @ t = 2) and a payback period for investment (b) of PBP = 4
(1000300>1000) @ t = 4). If the decision hurdle rate is 3 years (a very common
rate), then investment (a) is attractive but investment (b) is not. Hopefully, it
is obvious that judging (b) unattractive is not good decision-making, since
a $1,000,000 return four years after a $1,000 investment is attractive under
almost any value of MARR. In point of fact, the IRR for (b) is 465%, so for
any value of MARR less than 465%, investment (b) is attractive.
A.8 ECONOMIC ANALYSIS
A.8.1 Introduction
The general scenario for economic analysis is that a set of investment
alternatives are available, and a decision must be made regarding which
ones (if any) to accept and which ones (if any) to reject. If the analysis is
deterministic, then an assumption is made that cash flow amounts, cash
flow timing, and MARR are known with certainty. Frequently, although
this assumption does not hold exactly, it is not considered restrictive in
terms of potential investment decisions. If, however, the lack of certainty