## Dr. Ivo Welch's Corporate Finance (3rd Edition): "Chapter 4: A First Encounter with Capital Budgeting Rules"

Read section 4.4, which highlights a simple capital budgeting concept in finance that is used for making investment decisions. The payback period method is often used by small-business owners. Make sure to answer the questions given at the end of the section and compare your answers to the answers given at the end of the chapter.

The payback period (PP) method is a simple way for comparing the feasibility between projects. It is a measure that tells you how long a project takes to recover its initial investment. When choosing between projects, the PP rule is to accept that project with the shortest PP. For example, if project A takes 5 years to recover its initial investment but project B takes 1 year, then under this method it is best to choose project B. The PP method, as you can see, is very simple and may lead to erroneous decisions because it does not tell you anything about the size of the returns. Will you change your mind knowing that project A is a 7-year project that will give you a $50 million profit compared to project B that is a 2-year project that will only give you a $1 million profit?

The payback period (PP) method is computed by counting the time (in years, months, or days) that it takes for a project to recoup its initial investment. For example, suppose that a 3-year project that costs $100,000 will give you benefits of $50,000 in the first year, $100,000 in the second year, and $150,000 in the third year. The PP for this project is 1.5 years as it will take 1 year and 6 months to recover the entire $100,000. Notice that the net profit of this project is $200,000!