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A Note on the Payback Method**

Published online by Cambridge University Press:  19 October 2009

Haim Levy
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Extract

Two measures of investment worth: the discounted-rate-of-return and the payback method will be compared here. Many examples can be found in the literature illustrating the serious limitations of the payback method.

According to these examples, an investment proposal may be judged economically undesirable when in actual fact it is highly profitable. This happens when the annual cash flow is not equal, and the investment project promises a relatively large cash flow after the cut-off period.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 3 , Issue 4 , December 1968 , pp. 433 - 443
Copyright
Copyright © School of Business Administration, University of Washington 1968

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References

1 See, for example, Weston, J. F. and Brigham, E. F., Managerial Finance (Second Edition), New York, 1966.Google Scholar

2 See Gordon, Myron, “The Payoff Period and the Rate of Profit,” Journal of Business (October 1955).Google Scholar

3 From Table 2 we can draw iso-error curves for different combinations of k and n; the curves slope upward from left to right.

4 Gordon, op. cit.

5 See Terborgh, G., Dynamic: Equipment Policy: a Mapi Study (New York: McGraw-Hill, 1949).Google Scholar

6 The expression approaches zero more rapidly than since for every q < 1 there exists the following inequality:

7 When q = 1, the function is not defined because But

8 (1)

(2) and

(3)

hence

(4)

By imposing q = 1 (or log q = 0), we obtain:

(5)

But since , we get

, that is to say, the second derivative is positive.