The payback rule can be best stated as an investment is acceptable if its calculated payback period is less than some prespecified number of years.
The payback period is the time it takes for an investment to recoup its initial cost through cash inflows. This rule helps investors make quick decisions about the viability of an investment. If the payback period is shorter than the threshold they’ve set, the investment is considered attractive; if it’s longer, it may be deemed too risky or not worth the wait.
While this method is straightforward and easy to apply, it also has its limitations. It doesn’t account for the time value of money or the cash flows received after the payback period, which may lead to suboptimal investment decisions. Therefore, while the payback rule is a useful initial screening tool, it should be combined with other methods for a more comprehensive analysis.