Introduction to Finance

payback period method 
determines the time in years it will take to recover, or “pay 
back,” the initial investment in fi xed assets. Management will choose the projects whose pay-
backs are less than a management-specifi ed period. 
In cases where the cash benefi ts form an annuity, the payback period is easily calculated:
Payback period = Initial outlay∕Annual cash infl ow
For project A, we have payback period = $20,000∕$5,800 = 3.4 years.
The initial investment outfl ow for project B is $25,000. Cash infl ows for project B 
will total $16,000 ($4,000 + $4,000 + $8,000) for the fi rst three years. This leaves $9,000 
($25,000 – $16,000) unrecovered. With a $10,000 cash fl ow expected in year four, it 
will take an additional 0.9 of a year ($9,000∕$10,000) before the investment is recovered. 
Thus, the payback period for project B is 3.9 years. Based solely on the payback period 
technique, project A would be chosen over project B because it recoups its investment 
more quickly.
However, the payback period evaluation method suff ers from two drawbacks. First, the 
technique does not consider the time value of money. The second limitation is that all cash 
fl ows beyond the payback period are ignored. Project B will return $10,000 in cash infl ow in 
year fi ve, which is more than project A’s fi fth-year cash infl ow. The possible signifi cance of 
this diff erence is overlooked by the payback period method.
A large accounting fi rm conducted a study of store remodeling and renovations. Their 
fi ndings are disturbing for some retailers: these investments may never pay for themselves. 
The study found that large discounters, such as K-Mart and Target, have payback periods that 
average 20 years for renovation projects. The IRRs on such projects range from 1 to 6 per-
cent. For family apparel specialty stores (such as Eddie Bauer), it was a diff erent story. Their 
remodeling IRRs were as high as 67 percent with payback periods that averaged 19 months. 
(The participants in the study were not revealed; the store names used above are only examples 
of stores in the diff erent retail categories.)
The study concludes that having a good market position is more important to success than 
a renovation project. Poor returns on some stores’ renovations apparently occurred because 
stores were trying to modernize in the face of new competition rather than realigning company 
strategy to respond to a successful competitor.
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