The payback method compares projects by the amount of time that it
will take for income to offset expense. The prime weakness is that it
doesn't take into account the time value of money.
Because it doesn't account for the time value of money, there are several problems:
? it could lead to a negative real return
? it could lead to choosing a project with a lower TOTAL return
? it doesn't account for changes in inflation (i.e., cost of capital)
If you were to lend me $99 and choose one of two repayment plans in
today's American economy, which would you choose? The payback method
says, choose #1:
1. $33 per year for 3 years (payback = 3 years)
2. $25 per year for 6 years (payback = 3.96 years)
The following article was done for an electrical project but explains
graphically why payback is rarely used:
"Financial Analysis of Cogeneration Projects" (Carlos, Mar. 23-25, 2004)
Google search strategy:
"definition of payback"
"payback vs. NPV"