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# 金融代写|公司金融学代写Corporate Finance代考|THE PAYBACK PERIOD RULE

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## 金融代写|公司金融学代写Corporate Finance代考|THE PAYBACK PERIOD RULE

Defining the Rule
One of the most popular alternatives to NPV is the payback period rule. Here is how the payback period rule works.

Consider a project with an initial investment of $-\$ 50,000$. Cash flows are$\$30,000$, $\$ 20,000$, and$\$10,000$ in the first three years, respectively. These flows are illustrated in Figure 6.1. A useful way of writing down investments like the preceding is with the notation:
$$(-\ 50,000, \ 30,000, \ 20,000, \ 10,000)$$
The minus sign in front of the $\$ 50,000$reminds us that this is a cash outflow for the investor, and the commas between the different numbers indicate that they are received-or if they are cash outflows, that they are paid out-at different times. In this example we are assuming that the cash flows occur one year apart, with the first one occurring the moment we decide to take on the investment. The firm receives cash flows of$\$30,000$ and $\$ 20,000$in the first two years, which add up to the$\$50,000$ original investment. This means that the firm has recovered its investment within two years. In this case two years is the payback period of the investment.

The payback period rule for making investment decisions is simple. A particular cutoff time, say two years, is selected. 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-if at all-are rejected.
Problems with the Payback Method
There are at least three problems with the payback method. To illustrate the first two problems, we consider the three projects in Table 6.1. All three projects have the same threeyear payback period, so they should all be equally attractive – right?

Actually, they are not equally attractive, as can be seen by a comparison of different pairs of projects.

## 金融代写|公司金融学代写Corporate Finance代考|Managerial Perspective

The payback rule is often used by large and sophisticated companies when making relatively small decisions. The decision to build a small warehouse, for example, or to pay for a tune-up for a truck is the sort of decision that is often made by lower-level management. Typically a manager might reason that a tune-up would cost, say, $\$ 200$, and if it saved$\$120$ each year in reduced fuel costs, it would pay for itself in less than two years. On such a basis the decision would be made.

Although the treasurer of the company might not have made the decision in the same way, the company endorses such decision making. Why would upper management condone or even encourage such retrograde activity in its employees? One answer would be that it is easy to make decisions using the payback rule. Multiply the tune-up decision into 50 such decisions a month, and the appeal of this simple rule becomes clearer.

Perhaps most important though, the payback rule also has some desirable features for managerial control. Just as important as the investment decision itself is the company’s ability to evaluate the manager’s decision-making ability. Under the NPV rule, a long time may pass before one decides whether or not a decision was correct. With the payback rule we know in two years whether the manager’s assessment of the cash flows was correct.

It has also been suggested that firms with very good investment opportunities but no available cash may justifiably use the payback method. For example, the payback method could be used by small, privately held firms with good growth prospects but limited access to the capital markets. Quick cash recovery may enhance the reinvestment possibilities for such firms.
Notwithstanding all of the preceding rationale, it is not surprising to discover that as the decision grows in importance, which is to say when firms look at bigger projects, the NPV becomes the order of the day. When questions of controlling and evaluating the manager become less important than making the right investment decision, the payback period is used less frequently. For the big-ticket decisions, such as whether or not to buy a machine, build a factory, or acquire a company, the payback rule is seldom used.

## 金融代写|公司金融学代写Corporate Finance代考|THE PAYBACK PERIOD RULE

NPV 最流行的替代方法之一是投资回收期规则。以下是投资回收期规则的工作原理。

$$(-\ 50,000, \ 30,000, \ 20,000, \ 10,000)$$

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