Why do so many financial managers in the Solution Payback period is defined as t

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Payback period is defined as the period required for the incremental cash investment in a project to be recovered from incremental cash inflows. Mathematically, payback period is the period N(p) which solves: N(p) t = 1 C(t) = C(o) (1) where C(t)(t > 1) is net cash inflow in period t and C(o) is initial cash outlay for the project. Payback has a number of interesting properties which make it the most popular criterion in investment decision making. Among the five commonly used criteria--payback (PP), accounting rate of return (ARR), net present value (NPV), internal rate of return (IRR), and profitability index (PI)-- only payback contains a unique measurement unit--time to capital recovery. In addition, payback has other useful properties which smaller firms value. It is simple to understand and easy to calculate. Payback is also regarded as a measure of safety or resolution of uncertainty associated with a project. Payback emphasizes the liquidaty aspect of an investment decision and can be interpreted as a breakeven concept.5 Since distant cashflows are inherently risky, a shorter payback implies that the project is safe and will enhance liquidity of the firm. Academicians are unanimous in criticizing the payback method as unsophisticated and theoretically incorrect because it ignores the time value of money, ignores cash flows beyond the payback period, and is inconsistent with the owner's goal of maximizing wealth. The continued use of this method by practitioners, both in large and small firms, indicates that it has some unique properties which are not shared by other frequently used criteria, namely net present value, internal rate of return, accounting rate of return, and the profitability index. The purpose of this article is to introduce the discounted payback period criterion and to demonstrate to small business owners and managers that the DPP possesses all the useful properties of the traditional payback period (PP) criterion and overcomes its serious limitations. Small businesses, therefore, should consider substituting discounted payback for the more traditional payback criterion. The properties and limitations of the traditional payback technique are described, and the discounted payback approach is explained and illustrated. Both of these methods are compared with other popular capital budgeting techniques.

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