Question 7.6: Why is payback commonly used as a way of dealing with risk i...
Why is payback commonly used as a way of dealing with risk in investment projects?
Several surveys have shown that payback is widely used in practice. Drury et al. (1993)
showed that 63 per cent of firms surveyed used it often or always. However, their survey also indicated that only 14 per cent of firms used the payback method exclusively and did not combine it with a method that took account of the time value of money. Arnold and Hatzopoulos (2000) found that 68 per cent of all companies used payback in conjunction with one or more investment appraisal methods. The reasons why payback is commonly used to deal with risk in investment projects are as follows:
– it is a useful test for companies concerned about short-term liquidity;
– it focuses attention on the short term, which is more certain and hence less risky than the long term;
– it guards against unforeseen changes in economic circumstances.