Hi, welcome back to Finance For Non-Finance Professionals. In this video, we're going to talk about another capital budgeting tool that we use to decide where, when and how to spend the firm's money. The tool that we're going to talk about in this video is Payback Period, which you see commonly in the field used by practitioners a lot and I'd like to talk about some of the costs and benefits of using payback relative to the tool that we talked about in our last video, net present value. So, the idea behind payback is very simple. How long does it take back the initial amount that you invested? The decision rule is we'll invest, if the payback is less than X. Now, here this get's used a lot. Actually, we kind of use it a lot in terms of how long is it going to take, if I buy a new refrigerator, because my old refrigerator costs too much money to run. At what point will I make my money back on it? And so this idea of payback period sits well, I think in our psyche. Because if you think to yourself, if I spend all this money, how long is it going to take me to recover the money that I spend? And if it pays back in a year, then the rest is just kind of gravy and then I feel good about the rest of the profits that come in off of it once I've covered how much I spent on it. That nice sort of heuristic feel to payback is also one of the dangers of that metric too, because I'll talk about some of the psychological biases that go on when we use those kind of heuristics when making decisions. So, let's think about three projects and just g through a very simple example of how you would compute a payback. If I look at these projects, I've got a bunch f different cash flows coming in on these projects and project X, I'm going to spend $500. I'm going to get back 500, 250 and then nothing on the third year. So, when does this project paid back? When do I recover my initial $500 expenditure? I get it back at the end of year one wherever covered the full 500. So, the payback on this is one year. When do I get paid back on project Y, the second project here? I spend 500, I get $100 back. It hasn't paid back yet. At the end of year two, I get back another 200. Now I've collected 100 plus 200 is 300, it still hasn't paid back. I might say that I got the money back somewhere during year three. So by the end of year 3, the project has fully paid back and I've recovered the initial 500. We could get a little fancier than that if we wanted to. We could split up the year and say, in project Z, we could say, I spent $500, I got 300 bucks would hasn't paid back yet. And then if I got $400 in year 2, let's say, I would have gotten half of that 400 by the first half of that year. So, I would have gotten 200 in the first half of the year and then another 200 in second half of the year. So that $200 plus the $300 here, I would have paid back in 1.5 years okay? So three different scenarios, three different paybacks and then the question is capital budgeting rule is did it pay back soon enough for us to want to do the project? If our payback was two years, then projects X and project Z would meet our payback criteria. If our payback criteria was a project you have to payback in a year, only project X would meet that investment criteria. So, that's the way we use payback in practice. What are some of the good things about using payback? The good thing about using payback is that like we talked about all of week one, time is money. The further things are in the future, the less valuable they are to me today and payback does sort of incorporate that notion. It reflects the opportunity cost in the sense that I can't do something else with money I don't have. And so I'd rather have the money back sooner, so that I could do something else with the money. So, their opportunity cost is in there a little bit. The bad parts of payback though are real bad. There's really no cash after the payback. What if I've got a payback that doesn't pay back until three years? But then, it's a cash cow and tons of cash is coming in off the project. That all sort of gets ignored once I've met that hard rule of did you get paid back on time? So, the timing of the cash flow's that we talk about in week one isn't reflected in this heuristic. Neglect the timing of the cash flows too. How far out the discounting that we did in net present value? Trades off, whether a cash flow's coming in a year from now, three years now, five years from now. The timing in the cash flows isn't that well-articulated in the payback period and it neglects risk. There's no way to sort of risk adjust the payback period. I think that risk gets incorporated when manager say, well, this is a risky project, so I'll want to get paid back sooner. But as we'll talk about, that's kind of an awkward or blunt way of dealing with risk. In net present value, we could just use a higher discount rate to reflect the risk. So, the other thing that I want to talk about is that payback gives you sort of a arbitrary cutoff. What's a good payback to you? Should projects pay back in six months? Maybe if I'm retooling the bit ends of a machine process, six-month payback is the right thing to do. Maybe three-month payback is the right thing to do. Boy, if I'm building an oil rig platform, maybe five to ten years is the right payback to consider. It's really very context specific. It depends on the industry, it depends on the kind of project. I start to worry about whether a capital budgeting rule is really arms-length and objective as soon as managers start making arbitrary, and ad hoc decisions about what a good project is. That's one of, again, I'm not saying don't use payback, but I'm saying, there are some real serious things to consider when we see payback in practice. Of course, we liked NPV. So if you're going to compute a payback, why not put it next to an NPV? Let's think about the tradeoff between net present value and payback a little more carefully. Let's take a look at those three projects I had before, X, Y and Z and let's think about what the payback was. 1 year, 3 years, 1.5 years. Now if I compute a net present value at a 10% discount rate, what is that tell me? Well, by discounting these future cash flows, what do I get? These cash flows get discounted harder. These cash flows get discounted even harder and what gets payback the quickest is project X, but it's actually got the lowest NPV. What gets paid back the latest parent project three, but it's got an NPV. So, it's sort of in-between. NPV is giving me a different answer than payback. NPV incorporates the timing, the risk and the opportunity cost. Payback is just kind of a blunt rule is the cash coming back soon enough. So I'm not saying, don't compute a payback. But since you've got a spreadsheet open probably, why not compute a net present value put it next to the payback? Okay, let's wrap-up payback. It's a one of the weaker capital budgeting tools, I would say. I would use it, but I would only use it with caution. We accept projects whenever the payback is less than some cutoff rule X. Maybe that's three months, maybe that's five years. If you see it used around in practice, it's okay to use it. It's okay to talk to your managers about it, but I would always push back and say, well, if that's measuring the time to recovery, why don't we also use a net present value? Put that next to the payback and that will hopefully sort of flash out and give us two different dimensions to whether or not to accept, or reject the project. So again, payback can be a useful piece of information, but be very cautious about using it. And if you see it used in practice, always recommend that an NPV be computed as well.
