The goal of financial management in a company is to maximize the value of the company’s stock. Managers need ways to determine whether a project being considered will add value to their companies. This is the first in a series of three articles that will each discuss a method for evaluating the financial benefit of projects.
One easily understood and widely used method of analyzing new projects is the payback approach. If you’ve ever said something like “the new ________ will pay for itself in ___ years,” then you were using the payback approach. This approach tries to determine the “payback period” or length of time it takes to recover the initial cost of an investment using expected future after-tax cash flows.
Consider this example: Acme, Inc. is considering buying a new machine. The initial cost of the machine is $1 million. The machine has an expected life of five years and is expected to generate cash flows, net of all expenses, of $250,000 per year for each of those years. Acme uses the payback approach to analyze new projects and has determined that it will only accept projects that have payback periods of five years or less.
As shown in the table below, the payback period in this example is exactly four years, meaning that it will take four years before the initial investment of $1 million is “paid back” from the annual net cash flows of $250,000.
|Year||Expected Net Cash Flows||Progress Toward Payback|
Any cash flows that occur after the payback period are ignored under the payback approach. Since the cash flows in this example beat Acme’s goal of a five-year payback period, Acme will accept the project based on the payback approach. In practice, the numbers usually will not work out to exactly the end of a year, so we either have to use fractions of years or say that “payback occurs sometime during year ___.”
The payback approach has several advantages:
(1) It is easy to understand and use. Once the future cash flows are estimated, which admittedly can be quite difficult to do, the payback approach is very straightforward and the payback period can be easily and quickly calculated.
(2) The payback approach is biased towards liquidity, meaning that since it only considers the early cash flows of a project, it favors projects that free up cash for other uses more quickly. This can be a good thing for businesses that care about liquidity.
(3) The payback approach is based on the earlier cash flows of a project, which are usually easier to predict and can be predicted more reliably than later cash flows.
Unfortunately, the payback approach also has several significant shortcomings:
(1) It ignores the time value of money. A dollar earned near the end of the payback period is worth less than a dollar earned near the beginning due to inflation and inability to invest that dollar for as long, but the payback approach does not adjust for this.
(2) It ignores differences in risk of different projects. Two projects with similar cash-flow projections might have very different risk profiles, but identical payback periods. This makes it very difficult to compare projects using the payback approach.
(3) It uses an arbitrary cutoff to determine which projects to reject.
(4) It ignores cash flows that occur after the cutoff. The problem with ignoring later cash flows is that sometimes they can significantly affect the profitability of a project, either positively or negatively. The result is that the payback approach is biased against long-term projects.
Because of these shortcomings, managers will often supplement the payback approach with other analysis when considering major projects. Since the payback approach is so simple to use, many companies use it by itself to evaluate minor project decisions involving smaller dollar amounts.
Jon Allen (B.S. Brigham Young University, J.D. University of Idaho), teaches Introduction to Corporate Finance as an adjunct at Utah Valley University’s Woodbury School of Business. Before becoming Bank of American Fork’s Chief Compliance Officer, he was a commercial loan officer at Capital Community Bank. He volunteers on the Business Incubator Board of the Commission for Economic Development in Orem.