Video Transcript: "Simple Payback: The Simple Method"

…Payback before we move onto the present worth analysis

Remember, present simple payback is supposed to be the simplest of all techniques, and it's a common pre-screen that you'll see in some places, because it's so cheap, so easy to figure out that you do it before you hit some of the more complex and computationally-intensive methods.

It's relatively simple. All that you're looking for is the time it takes for you to be made whole.

As it described before, it's something that is very simple for people to understand: this is when they get their money back. It is often used in places where people are unwilling to discuss what an appropriate internal rate of return is. And it's also fairly frequently used in situations where there's a large group of people that are trying to come to an investment criteria. And, typically, you're going to find it in laws and public decision making processes.

So let's go ahead and get to our examples here. A common phrasing of a payback screen is that "we'll only consider investments which have simple payback of three years or less" (or less-than three years in this particular case). And let's go ahead and check into these investments that we have.

The first one we have is "Investment A." Investment A costs you $15 in period 0, and then after that gives you these $10 benefits. What you should notice is that, after that first years' purchase, you're $15 in the hole. Then, in period 1, you have an additional $10 coming in (so you're $5 below) and then what happens is — sometime between period 1 and period 2 — you cross that zero threshold, and by the end of period 2 you're $5 ahead.

Now, I would say that this thing has simple payback of between 1 and 2 years, but you'll see plenty of people that'll do linear interpolations to say something along the lines of "this thing has simple payback of 1.5 years," or something along those lines. Now, I've seen this quite a bit, it doesn't mean it's the "right" thing to do. I've seen, say, furnace systems that have a payback of 5.72 years and things like that. That doesn't make a whole lot of sense on a furnace system, since you usually use it only part of the year. It doesn't operate during the summertime (for the most part). But you see people going for this [unintelligible] level of precision that isn't actually there. Again, I prefer just between 1 and 2 years, that will be a correct answer for me.

Now, let's start hitting into the places where simple payback has problems. And we'll start with Investment B. Now, B, you can think of as kind of like an R&D project: you've got to spend a little bit of money, you spend a little bit of money, you spend a little bit of money, you spend a little bit of money, and then you hit these big payoffs that are over here on the other side.

Now, this thing does not meet the simple payback criteria. You're $10 in the hole, then you're $20 in the hole, you're $30 in the hole, and you're $40 in the hole by the time you're at period 3, so this thing clearly does not have appropriate payback. But, if you look at the whole sequence that's here, this probably looks like a pretty good investment for some moderate interest rates. Clearly if you're dealing with 1000% it doesn't seem like a good idea, but for most moderate interest rates, this looks like a pretty sweet deal that you're looking at here.

So, what you should think about with simple payback is that it's great for things like Asset A that have this single purchase and then you get some benefits, but not so good for R&D style projects. Now, part of it is the logic on how simple payback works. For anything less-than the cutoff date, it's as if the interest rate was zero, because things that are in period 0 and things that are in period 1 are treated as being in the same period. Everything after the cutoff date, after year 3, it's treated as if the interest rate is infinite. It doesn't really matter, that feature doesn't exist, you don't care. And that's one of the big drawbacks that you're going to have with simple payback: it doesn't deal with any kind of benefits that are in the future beyond that cutoff horizon that you have of your criteria.

Now, finally, we have the last problem that you're going to see with simple payback here in Asset C. With Asset C, you can see it's kind of cyclical. You have some costs, you have some benefits, then you have some costs again, then you have some benefits…you can think of this could be something along the lines of, say, replacing a ballast in a lamp, getting some energy savings, and then replacing the lamp again (or perhaps the lamp and the ballast again) and then receiving some energy savings. So, if you look at this one, you start off $15 in the hole, then the next year you're only $5 in the hole, then — some place between period 1 and 2 — you've had a payback, and now you're $5 up. Then, suddenly, you're $20 in the hole, and so on. You come back up again. The main point is this thing has many payback periods. So, again, simple payback criteria has a lot of problems when dealing with these kinds of cyclical investments.

So, again, just to reiterate the problems: simple payback is great when you have these simple investments, where you buy something and then it gives you some benefits. It's terrible with some R&D projects, things where the benefits are out in the future a little bit. It has some difficulty with these cyclical investments. Now, all the other kinds of criteria that we use are going to require a minimum set for rate of return. And, there are some modifications of simple payback that use the minimum set for rate of return, it's called "discounted payback," but the reality is that it's dressing up something that shouldn't be dressed up any more. If you're going to go through the effort of having a minimum set for rate of return, you should at least use one of the three other criteria: present worth, annual worth, or internal rate of return. Those are at least consistent and will give you the same answers no matter how you look at them. These kinds of discounted payback aren't necessarily going to do that.

Just remember that, this criteria, although it is useful, it is simple, it is cheap to do…

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