308 Planning and Forecasting
are f lawed. If the objective of the firm is to maximize investors’ wealth, the al-
ternative rules sometimes fail to identify projects that further this end and in
fact sometimes lead to acceptance of projects that destroy wealth. We will ex-
amine the payback period rule, the discounted payback rule, and the internal
rate of return rule.
The Payback Period
The payback period rule stipulates that cash f lows must completely repay the
initial outlay prior to some cutoff payback period. For example, if the payback
cutoff were three years, the payback rule would require that all projects return
the initial outlay within three years. Projects that satisfy the rule would be ac-
cepted; projects that do not satisfy the rule would be rejected.
For example, suppose a project initially costs $100,000 to set up. Suppose
the cash f lows in the first three years were $34,000 each. The sum of the first
three years’ cash f lows is $102,000. This is greater than the initial $100,000
outlay, and so this project would be accepted under the payback period rule.
There are two major problems with the payback period rule. First, it does
not take into account the time value of money. Second, it ignores what happens
after the payback. Because of these two failings, the payback rule sometimes
accepts projects that should be rejected and rejects projects that should be ac-
cepted. A project that costs $100,000 to set up and returns $34,000 for three
years would have a negative NPV at a 10% discount rate, since the $102,000 in
deferred cash f lows are worth less than the initial $100,000 outlay. Yet, the
project would be adopted under the payback rule criterion.
Consider a project that costs $100,000 to set up, returns nothing for three
years, and then returns $10 million in year 4. This project would have a posi-
tive NPV at any reasonable discount rate, yet would be rejected by the payback
rule. The rejection stems from the fact that the payback rule is myopic, that is,
it fails to take into account what happens after the payback period. Empirical
studies have shown that, contrary to popular perceptions, stockholders do re-
ward firms that take the longer view, NPV approach to project analysis.
The Discounted Payback Period
An improved, though still f lawed, variant of the payback period rule is the dis-
counted payback period rule. The discounted payback rule stipulates that the
discounted cash f lows from a project over some payback horizon must exceed
the initial outlay. If the horizon were three years, the rule would require that
the discounted present value of a project’s first three years of cash f lows be
greater than the initial outlay. Although this rule explicitly takes into account
the time value of money, it still ignores what might happen after the payback
horizon. A project may be rejected even if the expected cash f lows from the
fourth year and beyond are very large, as might be the case in a research and
development project. A project might be accepted even if there is a large