Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

IV. Capital Budgeting 9. Net Present Value and

Other Investment Criteria

© The McGraw−Hill^309

Companies, 2002

payback periodis two years. If we require a payback of, say, three years or less, then
this investment is acceptable. This illustrates the payback period rule:

Based on the payback rule, an investment is acceptable if its calculated payback

period is less than some prespecified number of years.

In our example, the payback works out to be exactly two years. This won’t usually
happen, of course. When the numbers don’t work out exactly, it is customary to work
with fractional years. For example, suppose the initial investment is $60,000, and the
cash flows are $20,000 in the first year and $90,000 in the second. The cash flows over
the first two years are $110,000, so the project obviously pays back sometime in the sec-
ond year. After the first year, the project has paid back $20,000, leaving $40,000 to be
recovered. To figure out the fractional year, note that this $40,000 is $40,000/90,000 
4/9 of the second year’s cash flow. Assuming that the $90,000 cash flow is received uni-
formly throughout the year, the payback would be 1^4 ⁄ 9 years.

Now that we know how to calculate the payback period on an investment, using the
payback period rule for making decisions is straightforward. A particular cutoff time is se-
lected, say, two years, and all investment projects that have payback periods of two years
or less are accepted, and all of those that pay off in more than two years are rejected.
Table 9.1 illustrates cash flows for five different projects. The figures shown as the
Year 0 cash flows are the costs of the investments. We examine these to indicate some
peculiarities that can, in principle, arise with payback periods.

CHAPTER 9 Net Present Value and Other Investment Criteria 279

payback period

The amount of time

required for an

investment to generate

cash flows sufficient to

recover its initial cost.

FIGURE 9.2

01234

–$50,000 $30,000 $20,000 $10,000 $5,000

Year

Net Project Cash Flows

Calculating Payback

The projected cash flows from a proposed investment are:

This project costs $500. What is the payback period for this investment?

The initial cost is $500. After the first two years, the cash flows total $300. After the third

year, the total cash flow is $800, so the project pays back sometime between the end of Year 2

and the end of Year 3. Because the accumulated cash flows for the first two years are $300,

we need to recover $200 in the third year. The third-year cash flow is $500, so we will have

to wait $200/500 .4 year to do this. The payback period is thus 2.4 years, or about two

years and five months.

Year Cash Flow

1 $100

2 200

3 500

EXAMPLE 9.2