Cost Benefits Analysis Example - Free Download | Page 4
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M M U
C o s t B e n e f i t A n a l y s i s t o o l k i t ( v 2 )
Page
4
4
1000
(600)
5
600
Zero
6
400
400
The payback period is precisely 5 years.
The shorter the payback period, the better the investment, under the payback method. The main
issue with this is that, even for a short period, there is a sacrifice to be made: an up front investment
with the hope that it will be “paid back” in the future (also called opportunity cost).
Another problem is when you are comparing several proposals, for example:
Project
Year
1
2
3
4
5
6
0
(50)
(100)
(80)
(100)
(8
0)
(100)
1
5
50
40
40
30
5
2
10
30
20
3
5
30
25
3
15
20
20
2
0
2
0
3
0
4
20
10
20
2
0
10
3
0
5
5
20
1
0
5
1
0
40
6
10
1
0
10
40
5
0
Payback period
4
3
3
4
3
5
Total after 6
years
5
40
40
30
60
80
The payback period for three of the projects (2, 3 and 5) is three years, so they seem to be of equal
merit.
However, because there is a time value constraint here, the four projects cannot be viewed as
equivalent. Project 2 is better than 3 because the revenues flow quicker in years one and two.
Project 2 is also better than Project 5 because of the earlier flows and because the post-payback
revenues are concentrated in the earlier part of that period. When you look at a longer time period,
the picture changes again: after 6 years projects 5 and 6 have the best yields, but although project 6
has the best overall yield, you have to wait the longest to get it.
Arguments in favour of payback
• It is simple! Research has shown that UK firms favour it. This is understandable given how
easy it is to calculate.
• In an environment of rapid technological change, systems may need to be replaced sooner
than in the past, so a quick payback on investment is essential.
Arguments against payback
• It lacks objectivity. It is decided by pitting one investment opportunity against another.
• Cash flows are regarded as either pre-payback or post-payback, but the latter tend to be
ignored.
• Payback takes no account of the effect on business. Its sole concern is cash flow.
Payback summary
It is best used as an initial screening tool, but it is inappropriate as a basis for sophisticated
investment decisions. In MMU it is OK for projects with budgets of up to £1 million. Projects with
greater costs should employ a more sophisticated analysis based on net present value (NPV) or
internal rate of return (IRR), as explained below.
