Defining the payback period and the payback period rule

A payback period is defined as the number of years we need to recover our initial investment. In the preceding example, we needed more than two years but less than three years to recover our $100 million investment since we recovered $60 million two years and $110 million in three years.

If the revenue is assumed to be distributed evenly within a year, the payback period of this project will be 2.8 years, as shown in the following code:

>>>40/50+2
2.8

The payback rule is that if the estimated payback period of our project is less than a critical value (Tcritical), we accept the project. Otherwise, we reject it, as given in the following conditions:

Compared with the NPV rule, the payback period rule has many shortcomings, including the fact that it ignores the time value of money and cash flows after the payback period, and the benchmark of the critical value is ad hoc. The advantage is that this rule is very simple.