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Challenges in advanced management accounting
Challenges in advanced management accounting

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4.2.2 Risk and the payback period

A similar way to adjust for risk is to shorten the length of the payback period, a technique known as adjusted payback period. A shortened payback period means that a project must pay back the initial investment more quickly in order to be acceptable. However it is still not recommended, as it still has all the issues of the payback period that make it only somewhat useful as a heuristic. NPV is the superior method of dealing with risk: if the discount rate is calculated correctly then cash flows further into the future will be given less weight due to higher discounting, but they will still be given some weight, rather than being ignored if they are after the payback period.

The same method of decreasing the acceptable payback period can also be used with the discounted payback period. This is an improvement on the payback period but still has most of the same problems. Also note that, whether you use the standard payback period or an adjusted one, and standard or discounted payback, the decision rule about whether to accept a project is still arbitrary. How many years is an acceptable payback time? There is no right answer since the payback rule does not consistently produce the best decision. Increasing the discount rate to deal with higher risk is a blunt instrument, but if risk is accounted for properly in setting a discount rate, then the decision rule is still clear: accept any project where NPV is greater than zero.