FortifyingThePaybackPeriodMethodForAlternativeCashFlowPatterns

AlbertE.Avery*
SusanM.V.Flaherty
MoonWhoanRhee
Abstract
Accordingtotheliterature,thepaybackperiodmethodisoftenusedalongwithnetpresent
value(NPV)andinternalrateofreturn(IRR)forevaluationofcapitalprojects.Despiteits
simpleandintuitiveapproach,thepaybackmethodhasbeencriticizedintheliteratureforits
failuretoconsiderthecashflowsbeyondthepaybackperiod.Sinceitisdifficulttoproject
future cash flows accurately, investment proposals with a short payback may be more
attractivetothepractitioner than suggestedby NPV or IRR. In addition, growth rates are
very common to the vernacular of business, so there may be particular advantage to
incorporation of cash flow growth rates into the calculation of the payback period. A two
fortifiedpaybackcalculationscanbeusedtosummarizeprojectedfuturecashflows,andthey
areeasilytocompute.Thefirstisbasedontheratiooftheinitialoutlaytothefirstperiod
cashflowandtheprojectedcashflowgrowthrate.Theresultingpaybackperiodsbehaveas
one would expect with respect to this ratio, varying growth rates and the subsequent
augmentationofthecomputationtoinclude discountedcashflow.

INTRODUCTION
Inchoosingacapitalbudgetingdecisiontool,academicsrecommendnetpresentvalue(NPV)as
theprimarytoolfollowedbytheinternalrate ofreturn(IRR) measure.Thepaybackperiod method is
alsopresentedbutistreatedasadecisionaid.1 Asadecisiontool,thepaybackperiodmeasureistypically
regardedasintuitivelyappealingbutwithlittlepracticalrelevanceduetoitsshortcomings.Thepayback
methodhasbeencriticizedintheliteratureforitsfailuretoconsiderthetimevalueofmoneyandalsofor
ignoringcashflowsthatoccurafterthepaybackperiod.(BlockandHirt[2005]andRushinek[1983]).
Despite the limitations of the payback and discounted payback measures, Graham and Harvey
(2001)findthatfirmsdousethesemethodsinevaluatingcapitalbudgetingdecisions.Inasurveyof392
CFOs, Graham and Harvey find that 56.7% (always or almost always) use the payback period. In
addition,largefirmspreferpresentvaluetechniqueswhilesmallfirmspreferthepaybackperiodcriterion.
Consideringthatsmallerfirms mayfacegreaterriskduetoalackofdiversification,it makessensethat
theytendtocaremoreaboutdownsiderisk,whichwouldmakepaybackamoreappealingchoice.
Ifthepaybackperiodmethodisinferiorrelativetopresent valuetechniques,whyarefirmsstill
usingitasaprimarydecisiontool?Whilethepaybackperiodmaybelesssophisticated,itscontinueduse
suggeststhatmanagersfindsomevalueinitsresults.Wesuggestthatthepaybackperiodmaybeamore
useful measure withsomeaugmentation orfortification. A methodforcalculatingapaybackperiod is
demonstrated,withcashflowsaregrowingataconstantrate.
This method of payback period calculation attempts to quantify management perspective as to
why the payback period measure is useful in capital investment decisions. It is shown that a payback
period can be used to summarize projected future cash flows by capturing two primary factors of cash
flows,namely,theratio(I)ofinitialoutlaytothenextperiodprojectedcashflow,andtheprojectedcash
*

Avery, Flaherty and Rhee are from Towson University. Their emails are avery@towson.edu,
sflaherty@towson.edu,and mrhee@towson.edu respectively.
1
AndersonandPrakash [1990]arguedthatthepaybackperiodcouldbe envisionedasaprojectduration,andthe
paybackmethodprovidedthesameinvestmentdecisionastheNPVunderaspecificformofcashflowprogression.
Boardman,Reinhart,andCelec[1982]supportedtheuse ofthepaybackmethodwhenfacedwithdecliningfinancial
liquidity. Block and Hirt [2005] commented that most corporations use a maximum timehorizon of three to five
yearsincorporateplanning,andarapidpaybackmightbeparticularlyimportanttofirmsinindustriescharacterized
byrapidtechnologicaldevelopments.

flow growth rate (g). Knowing that the payback period is positively associated with the ratio I and
negativelyrelatedtog,themanagementcanbetterassessatradeoffbetween thecostandthegainsofthe
project.Thisstudyisalsoextendedtoincorporatediscountedcashflowstoadjustforthetimevalueof
money.Interestingly,thediscountrateactslikeanegativegrowthrateindeterminingthepaybackperiod
whencashflowsexhibitsexponentialgrowth.
Thepaperis organizedasfollows.Insectionstwoandthree,thepaybackperiodcalculationis
presented with the assumption of constant growth in cash flows, with and without discounting, and
explicit closed form solutions for the payback period are provided. In section four, the assumption of
exponentialgrowthofcashflowsisrelaxed.Asimplelinearregressionisrunonthelogarithmicvalueof
thecashflowsagainsttimeisusedtoextracttheapparentorapproximateconstantgrowthrate.Section
fiveprovidesconcludingremarks.
PAYBACKPERIODWITHCONSTANTGROWTHANDWITHOUTDISCOUNTING
Themeasuredevelopedbelowapproachesthepaybackmodelusingacashflowperspectiveand
assumesthatcashflowsareexpectedtogrowataconstantrate.Stockvaluationtechniquesoftenmake
thisassumptionthat dividendswillgrowataconstantrateand,basedonthatassumption,astockprice
canbe determined.Thechoice ofthe growthrateis subjectivebut suggests that earnings will growat
somerateandultimatelytranslateintodividendgrowth.Therefore,thechoiceofgrowthrate,g,isbased
on knowledge of how much a firms earnings will grow and the amount of earnings retained and
reinvested,inflation,and/ortherateofreturnacompanyearnsonitsequity.
Thissamelogicisappliedtothepaybackperiodmeasurewithaconstantgrowthassumptionthe
choiceofgrequiresknowledgeofthefirmsactivityandforesight.Theassumptionofconstantgrowthis
reasonableforseveralreasons includingthe difficultyinforecastingcashflows beyondacertainpoint,
especiallyamongsmallfirms,andthecashflowsgeneratedfromaparticularproductorprojectlifecycle
beinguncertain.Thedecisiontoincorporateexponentialgrowthcanbejustifiedonthesamebasisasthe
geometric progression used in the Gordon constant growth stock valuation model, even if the validity
remains an empirical question. Using the same constant growth assumption and the same geometric
progression as in other models, we show that the payback period is simply the Future Value Interest
FactorforanAnnuity(FVIFA)capturingtheprimaryfactorsofIand g.
ModelDevelopment
Thepaybackperiod,T,isthelengthoftimeittakestorecovertheinitialinvestmentofacapital
investmentproposal.Inthisinitialdiscussion,thefirstperiodcashflowisassumedtobe$1,sothisratio,
I,willbetheinitialinvestmentdividedby1,orsimplytheinitialinvestment.
Anadditionalassumptionisthatcashflowssubsequenttothefirstperiodareexpectedtoincrease
ataconstantrateofgpercentperperiod.Sincethepaybackperiod,T,isthelengthoftimetorecoverthe
initial investment, T can be determined using Equation (1).2 The payback period, T, satisfies the
following:
(1)
Note that the left hand side of the equation is exactly the future value of a $1 annuity at the
interestrateofg%andTperiods.Indeed,theannuityvaluecanbeobtainedas(1+g)T1 +(1+g)T2 +
+(1+g)2+(1+g)+1,whilethesuminEquation(1)is1+(1+g)+(1+g)2 ++(1+g)T2 +(1+
Tl
g) .
2

Thefirstperiodcashflowisnormalizedto$1forsimplicity.Aslongasthefuturecashflows
growataconstantrate,onlytherelative sizedifference betweenthe initial investment andthe
firstperiodcash flow matter.gisadecimal number,butreferencedasapercentagenumberas
wellforconvenience.

The payback period T can be easily found using a factor to calculate the future value of an
annuity. Using common terminology, this Future Value Interest Factor for an Annuity (FVIFA) with
interestrate gforTperiodsmustbeequaltotheinitialinvestmentI.
FVIFA(g%,T)=I
Alternatively,explicitlysolvingforT,Equation(1)canberewrittenas:
=

(2)

Then,theequationcanbetransformedusingnaturallogarithmsand TtoobtainEquation(3).3
=

(3)

Thus,wehaveaclosedformsolutionforthepaybackperiodformulatedonthebasisofratioof
thedollarsizeoftheinitialinvestmenttothedollarsizeofthefirstperiod'snetcashflow.
Supposeaprojectrequiresaninitialinvestmentof$1,000,theexpectedcashflowforthefirst
periodis$100,andthesubsequentcashflowsareexpectedtogrowat7%.Theworkaboveassumedthat
theinitialcashinflowwas$1.Now,itistheratioofthesizeoftheinvestmenttothefirstyearcashflow
thatbecomesimportant.Here,theratiooftheinitialinvestmenttotheexpectedfirstperiodcashflowis
10,so I=10and g=0.07or7%.UsingtheFVIFA,weneedtofindTsatisfying:
FVIFA(7%,T)=10
Fromastandard FVIFAtable,Tiscloseto,butalittlelessthan8periods.UsingEquation(3),T =7.843.
Three figures are presented to illustrate relationships among the payback period, T, the growth
rate,g,andtheratiooftheinitialinvestmenttotheexpectedfirstperiodcashflow,I.Parametervalues
for figures are chosen to cover a wide range of payback periods, from 1 to 30.4 The growth rate per
period,g,rangesfrom5%to30%andtheinvestmenttofirstperiodcashflowratio,I,rangesfrom1to
15.Figure1plotspaybackperiodsfordifferentgrowthratesandvaluesofIinthreedimensionalspace.
ThepaybackperiodincreaseswithI,anddecreaseswithg.Tobetterunderstandfundamentalaspectsof
thoserelationships,twoadditionalplotsareprovided.
Figure2plotstherelationshipbetweenpaybackperiod,T,andtheinvestmenttofirstperiodcash
inflowratio,I,forgivenvaluesofgrowthrate g.AsIbecomeslarger,thepaybackperiodincreases.The
rate of increase depends on the value of g. When the growth rate g is negative, the payback period
increasesexponentiallyastheratio Ibecomeslargerandthepaybackcurveisconvexinshape.5
Whenthegrowthrategiszero,thepaybackperiodincreasesproportionallywithIwhereT=I,
reflectingalinearrelationship.However, whenthe growthrateg ispositive,theslope ofthepayback
perioddecreasesmonotonicallyandtheshapebecomesconcave.Thedegreeofconcavityincreasesasthe
growthrategincreases,therebydemonstratingthattheincreaseinthepaybackperiodTisdiminishedat
increasinglyhighgrowthrates.Inotherwords,therateofchangeinpaybackperiodbecomessmaller.
Figure3showsrelationshipbetweenthepaybackperiodTandthegrowthrateg,givenspecific
valuesoftheratio I.Asthegrowthrate gincreases,theassociatedpaybackperioddecreases.Indeed,the
paybackperiodTdecreasesexponentiallywhenratioIislarge.Inotherwords,theshapeofthepayback
3

ln stands for the natural logarithm function. To solve for T, a logarithmic function with any
basewouldwork.However,thenaturallogarithmworksbesttoapproximatevaluesaroundIn(l).
4
Thisstudyemploysannualtimeperiods.Thus,T=30implies30years.
5
Evenifthegrowthrateg isnegative,thepayoutoftheinvestmentprojectisstillpositive.

periodcurvebecomes more convexasIincreases.Asthegrowthrategincreases,thereductioninthe

paybackperiod TbecomesmorepronouncedathigherlevelsofI.
Insummary,thepaybackperiodispositivelyassociatedwiththeratioIandnegativelyrelatedto
g.WhenI is high,the costof initial investment relativetothe expected firstperiod cashflowis high.
Thus,itwouldtakealongertimeforaninvestortorecovertheinitialinvestment.Conversely,wheng,
thegrowthrateoftheexpectedcashflowsishigh,it takesashortertimeforaninvestortorecoverthe
initial investment. The shape of the three dimensional diagram reflects more complex nonlinear, yet
sensible,relationshipsamong T,I,and g.
Thus,apaybackperiodcapturestwoprimaryfactorscharacteringtheprojectedcashflows,Iand
g.TherelationshipsamongT,I,and gallowsinvestorstoconsiderfuturecashflowsbeyondthepayback
periodevenifapaybackisonlyexplicitlydeterminedbasedonthecashflowsupthepaybackperiod.We
alsointerpretouranalysisinthecontextofapriceearningsapproach,asitcanbethoughtofasmeasuring
thenumberofperiodsittakesforastockpricetobepaidforbyearningsasGrahamandHarvey(2001)
described.Here,IandgcanbethoughtofasaprojectedP/Eratioandaprojectedearningsgrowthrate
respectively.AninvestorcanrecovertheinvestmentinastockmorequicklyastheprojectedP/Eratiois
lowerandtheprojectedearningsgrowthrateishigher.
PAYBACKPERIODWITHDISCOUNTING
Oneofthecriticisms intheuseofthepaybackperiodfordecisionmakingisthattimevalueof
money is not considered.Inthis section, expected cash inflows arediscountedbackto thetime ofthe
initialinvestment.Again,thelogicoftheGordongrowthmodelisapplied.Withdiscounting,Equation
(1)canbeslightlymodifiedandberewrittenasinEquation(4),
(4)
where risthediscountrateperperiod.Theexactpaybackperiod Tinthiscasecanbecalculatedas,
(5)
Infact,Equation(5)isaspecialcaseofEquation(3)when r=0.
Suppose the project described earlier has anappropriate discount rate of 5%, then T becomes
9.663,whichisgreaterthanthe7.843paybackperiodcalculatedwithoutdiscounting.Thisisintuitively
correct. When future cash flows are discounted, it takes longer to recover the initial investment of
$1,000.
Alternatively,Equation(4)canbeapproximatedas,
(6)
According to Equation (6), when
is not equal to r, the payback period T can be estimated
usingan"adjustedgrowthrate,"(gr)%,withthediscountratebeingconsideredasanegativegrowth
rate.ThepaybackperiodforoursampleinvestmentproposalbasedtheEquation(6)is9.27.6
PAYBACKPERIODWITHNONCONSTANTGROWTHINCASHFLOWS

TheapproximatepaybackperiodwithdiscountingcanalsobeobtainedbasedontheFIVFA
tablewiththeadjustedgrowthrate(g r)%.

The simple framework thus far described is limited to the situation where the growth rate is
constantbetweenthetimeofinvestmentandthecalculatedpaybackperiod.Considerthesituationwhere
the growth rate is not constant. The logic used to develop the supernormal (or nonconstant) growth
modelforstockvaluationcanbeextendedtothepaybackperiodmeasurewheretheexpectationoffuture
cashflowsofsomehorizonvalueisincluded.
If the rate of change in this growth rate is not entirely erratic, it becomes reasonable to
mathematicallyestablishaneffectiveoverallgrowthratetouseinestablishingpaybackperiod.Suppose
thatthecashflowsoccurevenlyovertheperiods.Then,thepaybackperiodcanthenbecomputedusing
theequation,
= [

] +
(7)

whereCNCFstandsforCumulativeNetCashFlow,calculatedascumulativenetcashreceiptsminusthe
initialinvestment.
Suppose the initial investment is $1,000 and the subsequent cash flows and their associated
CNCFs,andregressionestimatedconstantgrowth ratemodelcashflowsareasshowninTable1.
ThehypotheticalinvestmentproposalportrayedinTable1hascashflowsthatdeclineovertime.
Figure4graphicallydepictstheseprojectedactualandregressionestimatedcashflows.
Running a simple regression of logarithmic of cash flow against time leads to a least squares
estimatorforacumulativenetcashflow(CNCF)growthrateof39.12%.Theregressionestimatedfirst
periodcashflowis$525.30and,giventheinitialinvestment of$1,000,theresultinginvestmenttofirst
period cash flow ratio, I, is 1.904. Given these values, the previously discussed constant growth rate
modelscanbeusedtodeterminepaybackperiodandinvestigateissuesofsensitivitytoerrorintheinput
variables.
ForthisexampleandusingEquation(7),thepaybackperiodis2.5.Followingtheearlierlogicon
cash flow growth, the scenario in which net cash flow is declining implies that more of the cash flow
mightbereceivednearthebeginningofaperiodthan attheend.
Thissuggeststhatthepaybackperiodshouldactuallybelessthan2.5.CalculatedusingEquation
(1), a growth rate of 39.12% andI estimated earlier, yields a payback period of 2.752, which is even
higherthan2.5.Thisresultiscontrarytointuitiveexpectations.However,eventhoughthefirstperiod
estimated cash flow is greater than the projected actual figure ($525.3 versus $500), the 2nd period
cumulative estimated cash flow is less than the cumulative projected actual cash flow ($880.6 versus
$900).This resultsinashortertimetorecoverthe initial investment usingprojectedactualcashflows
andthesmaller2.5paybackperiodobtainedfromEquation(1).
CONCLUDINGREMARKS
Inthispaper,asimplewaytodetermineapaybackperiodispresentedwhenthecashflowsare
expectedto growataconstant rate,withand without time value of moneybeingconsidered.Constant
growthis employedinotherpopularfinancialvaluationmodels,includingthedividenddiscount model,
and seems equally appropriate here. Given the constraints of forecasting and imperfect foresight of
projectbasedcashflows,theconstantgrowthratemodelwithafinitenumberofperiodsisareasonable
approachtoimprovingtheusefulnessofthepaybackmodel.
We show that a payback period can be used to summarize projected future cash flows by
capturingtwoprimaryfactorsofthecashflows,namely,theratio(I)ofinitialoutlaytothenextperiod
projected cash flow, and the projected cash flow growth rate (g). The payback period is positively
associatedwiththeratioIandnegativelyrelatedtog.Undertheseconditions,itisalsoshownthatthe
paybackperiodisaFutureValueInterestFactorforanAnnuity(FVIFA).Thestudywasalsoextendedto
incorporate discounted cash flows to adjust for the time value of money. In this situation and with

exponential cash flow growth, the discount rate acted like a negative growth rate in determining the
paybackperiod.
Future development of these ideas could include a focus group of practitioners to determine
whether these augmentations are viewed as valuable in the capital budgeting decision making process.
On a more academic level, the approach in this paper could be used to estimate to apparent payback
periodsinvariousindustrygroupings.Itwouldalsobeinterestingtoinvestigatetherelationshipbetween
constant growthrateinvestment proposals acceptedunderpresent value methods andthoseselectedby
paybackfindingsinbothcrosssectionalandlongitudinalanalyses.

REFERENCES
[1] Anderson, G. and J. Prakash, 1990, A Note on Simple Resource Allocation Rules: The Case of
ArithmeticGrowth,JournalofBusinessFinance&Accounting,175,759763.
[2]Block,S.andG.Hirt.2005. Foundations ofFinancialManagement,11thed.,NewYork:McGraw
HillIrwin.
[3] Boardman, C., W. Reinhart, S. Celec, 1982, The Role of the Payback Period in the Theory and
Application of Duration to Capital Budgeting, Journal of Business Finance and Accounting, 94,
511514.
[4]Rushinek,A.,1983,CapitalBudgetingTechniques,thePaybackPeriod,theNetPresentValue,the
InternalRateofReturnandTheirComputerApplications,ManagerialFinance,91,1113.

Figure1:PaybackPeriodT,RatioI,andGrowthRateg

30

25

20

15 T

Figure2:PaybackPeriod Tvs.RatioI

25%

5%

5%

15%

15
14
13
12
11
10
9
8
7
6
5
4
3
2

10

Figure3:PaybackPeriod Tvs.GrowthRateg

Figure4:Actualvs.EstimatedCashFlow
600

500

400

300

200

100

0
1

CashFlows

Table1:CashFlowsandCNCFs
YEAR
CASHINFLOW
1
500
2
400
3
200
4
200
5
100

CNCF
500
100
100
300
400

EstimatedCF

EstimatedCF
525.3
355.3
240.2
162.4
109.8

EstimatedCNCF
474.7
119.4
120.8
283.2
393.0