Okay so we talked about book return last time and we know now that that's not a very good way to evaluate investment. Now let's talk about the project payback period. Okay so some companies may require and I think, I would actually say it's fair to say strangely enough some companies may require that an investment in the project be recovered over a certain amount of time. And to me that's inconceivable because it just makes no sense at all but some companies do that. In the payback period as we discussed I think earlier is determined by counting the number of years it takes before the cumulative cash flows that are coming out in the future equals the initial investment, okay? That's what payback period is. So let's look at this example I can show you why payback period makes no sense. I have three projects, A, B, and C. All of them have an initial investment of $2,000. But the cash out to all three of the projects is the same. So I'm starting on equal ground. But, the cash returns are different for all 3 projects. For a, we have 500 in year 1, 500 in year 2 and a big $5,000 dollar payout in year 3, which is maybe an acquisition or a sale, sold a company to a big company or [INAUDIBLE]. Project B, you have $500 in year 1, 1,800 in year 2 and nothing in year 3. And Project C has 1800 in Year 1 and 500 in Year 2 so you just took Project B and you reversed it. You reversed the cash flows in that example. Both of those projects B and C have no cash return in Year 3. So, if you calculate the payback for those projects, it takes project A three years before the cumulative cash flow, now remember, you're looking at cumulative, so 500 the first year, 500 the second year, that's 1000. And then 5000 the third year. Even though you may have earned that in the first couple of months, you say it's a three year payback. Okay, so they have a three year payback. And then, projects B and C, those have two year paybacks. In investing 2000, they're returning 2300 of a two year period. They have two year paybacks. Now, the problem with payback rules, is that it gives you misleading results because it ignores all the cash flows that happen after the cutoff date. But when you recover the payback of the project, and in Project A's case that's where most of the cash flows happen, so it gives equal weight to all the cash flows that happen up to that date. So let's say this company has a cutoff date rule, they have a rule that says every project must return, have a payback of two years or less. If they do that, only B and C would be accepted, as project to invest in. But look at the answers that they get by doing that. Project A has a 3 year payback but the net present value at 10%, their hurl rate, is $2600. Project B, has a negative net product value, and project C has a very small net product value. So the only investment you should be making, is A. And because you have a pay back period of more than two years, you don't make the investment. It just makes no sense to me. And I think a lot of companies are now going away from this. Although, you know, traditions die hard. So just, be aware of the fact that this may be something that you run into and if you run into it, feel free to pull the slide out and show the people that it doesn't make any sense. You can use this in a way, I guess, that's more meaningful but it would require that you determine a more appropriate cutoff date for your project. I just don't like it. So we'll talk about IRR next.
