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Abstract
The Payback Period is one of the most popular project evaluation criteria. As much as it is liked by practitioners as a measure of liquidity and risk exposure, it is criticized by academicians who seriously question its validity as a profitability criterion. This paper examines the classical definition of the Payback Period criterion for investment projects, and re-formulates this criterion in a way that frees it from the shortcomings of the old definition and makes it compatible with the Net Present Value criterion. It is also shown that the traditional approach to the comparison of mutually exclusive projects by means of the Payback Period criterion has been inadequate, and the proper approach to this problem is presented.
Introduction
The Payback Period (PBP) project evaluation criterion, which has been applied since the beginning of this century, has been one of the most popular project evaluation criteria, despite its criticism in academic circles [2,7,8,10,11, 13,14,15,16,18,19,22,23,26,29]. The reasons for the continuing popularity of the PBP criterion are as follows [3,7,15,18,19,25,26,28,29]:
1. The PBP is simple to calculate and easy to understand; it also provides a single number which can be used as an economic measure.
2. In the original version of the PBP, no interest calculation, and, therefore, no decision as to the magnitude of the Minimum Attractive Rate of Return, is required.
3. The PBP hedges against uncertainty of future cash flows, thus saving management from exposure to excessive risk.
4. The PBP provides an approximate liquidity measure of an investment and minimizes the lost opportunity risk to the firm.
5. The selected PBP reflects a manager's attitude when investment capital is limited.
6. It also reflects the manager's attitude resulting from the "principal-agent" relationship.
The PBP approach is particularly appealing to, and widely applied in, the minerals industry [7] which is both capital-intensive and exposed to considerable risk. This is especially true with respect to small mining companies without large capital reserves [27].
The PBP criterion, like the Internal Rate of Return (IRR), was originally formulated for the classical cash flow pattern (CFP) of an investment project (IP) with one change of sign, characterized by one or more negative cash flows (CFs) followed by a sequence of positive ones. A subsequent realization that projects...