Payback Period: Often "Wrong"
The payback period method of evaluating projects is
extremely bad as a general rule--it has, however, been defended as reasonable
by otherwise bright people in some of my classes, so we shall consider
it. The idea is that projects should be selected that "pay back"
the investment most quickly. Indeed, among the many problems in the
former communist systems, their use of the payback period approach stands
out. The reason they typically used this method was that it was philosophically
wrong in their "labor theory of value" to employ the interest-rate approaches
of the capitalist dogs. Capital, in their view, was merely "embodied
labor," not meriting a separate price--Marx believed the interest returns
to the capitalists would make the bourgeoisie rich while labor was kept
at a subsistence wage via Malthusian breeding notions. At any rate,
to see the problems a simple example will suffice:
Year 0 Year 1 Year
2 Year 3 Year 4
Year 5 etc.
Project A -$1,000
+$500 +$500
-0- -0-
-0- ....
Project B -$1,000
+$400 +$400 +$400
+$400 +$400 ....
Project A would be preferred under the payback period approach, yet
it does not even have a positive NPV--it shouldn't even be done!
Project B, having a large NPV of $3,000 would be ranked behind Project
A. It is sometimes argued that new businesses have so little in cash
reserves that they are forced to pursue payback period approaches to survive--an
alternative view is that so many small businesses go under each year (3
out of 5 don't survive five years) because they are using stupid decisionmaking
mechanisms!