Agriculture Reference
In-Depth Information
Plate 13.2
Extended hands
The payback period is the length of time it takes an investment to pay for itself. Photo courtesy of
USDA Natural Resources Conservation Service.
Generally, the shorter the payback period, the better the investment is rated. So it would
appear from this simple method that the fertilizer applicator is the better alternative because
it will pay for itself in two years, compared to 4.5 years for the additional grain storage.
The payback method only indirectly considers risk in the decision process. The payback prin-
ciple suggests that by accepting the project with the lowest payback, that project has the lowest
risk. This is based on the investor desiring the cash fl ow as soon as possible due to the uncertainty
involved in receiving the cash and the opportunity to reinvest that cash sooner with a shorter pay-
back period. Here, the manager is assumed to be comparing similar investment options and time
is the primary risk factor under consideration. Thus, an investment that is repaid by cash fl ows in
two years involves less risk than a project that pays back its original investment in 4.5 years.
The payback period method is widely used, partly because of its simplicity. But it ignores the
length of life of the investment. In this example, the additional grain storage lasts for 20 years,
while the applicator lasts only fi ve years with regular cash fl ows. Now, the decision is more com-
plicated and the payback period does not capture the difference in the life expectancy of the two
investments. In such a case, a more sophisticated investment evaluation method is needed. Although
this limitation is a serious drawback, when cash fl ow is critical, the payback method is useful.
In a somewhat similar limitation, the payback method ignores cash fl ows generated after
the payback period. Hence, payback gives more weight to those investment alternatives that
have the majority of cash fl ows generated early in the life of the project or investment
alternative. Some investments may generate small cash fl ows early due to various startup
costs, but the cash fl ow may increase over certain periods of the lives of alternative invest-
ments. These cash fl ows would be ignored when compared to an investment that generates
the majority of its cash fl ow in the fi rst few years.
