Budgeting Basics and Beyond

20.3. Payback Reciprocal

Payback reciprocal is the reciprocal of the payback time. This often gives a quick, accurate estimate of the internal rate of return (IRR) on an investment when the project life is more than twice the payback period and the cash inflows are uniform every period.

Example 4

ABC Company is contemplating three projects, each of which would require an initial investment of $10,000, and each of which is expected to generate a cash inflow of $2,000 per year. The payback period is five years ($10,000/$2,000) and the payback reciprocal is 1/5, or 20 percent. The table of the present value of an annuity of $1 shows that the factor of 5.00 applies to these useful lives and internal rates of return:

Useful Life	IRR
10 years	15%
15	18
20	19

The payback reciprocal is 20 percent as compared with the IRR of 18 percent when the life is 15 years, and 20 percent as compared with the IRR of 19 percent when the life is 20 years. This shows that the payback reciprocal gives a reasonable approximation of the IRR if the useful life of the project is at least twice the payback period.