Notwithstanding all of the preceding rationale, it is not surprising to discover that as the decisions
grow in importance, which is to say when firms look at bigger projects, NPV becomes the order of the
day. When questions of controlling and evaluating the manager become less important than making the
right investment decision, payback is used less frequently. For big-ticket decisions, such as whether or
not to buy a machine, build a factory, or acquire a company, the payback method is seldom used.
The payback method differs from NPV and is therefore conceptually wrong. With its arbitrary cutoff
date and its blindness to cash flows after that date, it can lead to some flagrantly foolish decisions if
used too literally. Nevertheless, because of its simplicity, as well as its other mentioned advantages,
companies often use it as a screen for making the myriad of minor investment decisions they continually
face.
Although this means that you should be wary of trying to change approaches such as the payback
method when you encounter them in companies, you should probably be careful not to accept the sloppy
financial thinking they represent. After this course, you would do your company a disservice if you used
payback instead of NPV when you had a choice.
5.3 The Discounted Payback Period Method
Aware of the pitfalls of payback, some decision makers use a variant called the
discounted payback
period method.
Under this approach, we first discount the cash flows. Then we ask how long it takes
for the discounted cash flows to equal the initial investment.
For example, suppose that the discount rate is 10 percent and the cash flows on a project are given
by:
(–$100, $50, $50, $20)
This investment has a payback period of two years because the investment is paid back in that time.
To compute the project’s discounted payback period, we first discount each of the cash flows at the
10 percent rate. These discounted cash flows are:
[–$100, $50/1.1, $50/(1.1)
2
, $20/(1.1)
3
] = (–$100, $45.45, $41.32, $15.03)

The discounted payback period of the original investment is simply the payback period for these
discounted cash flows. The payback period for the discounted cash flows is slightly less than three years
because the discounted cash flows over the three years are $101.80 (= $45.45 + 41.32 + 15.03). As
long as the cash flows and discount rate are positive, the discounted payback period will never be
smaller than the payback period because discounting reduces the value of the cash flows.
At first glance discounted payback may seem like an attractive alternative, but on closer inspection
we see that it has some of the same major flaws as payback. Like payback, discounted payback first
requires us to choose an arbitrary cutoff period, and then it ignores all cash flows after that date.
If we have already gone to the trouble of discounting the cash flows, we might just as well add up
all the discounted cash flows and use NPV to make the decision. Although discounted payback looks a bit
like NPV, it is just a poor compromise between the payback method and NPV.

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