The payback reciprocal is a crude estimate of the rate of return for a project or investment. The payback reciprocal is computed by dividing the digit “1” by a project’s payback period expressed in years. For example, if a project’s payback period is 4 years, the payback reciprocal is 1 divided by 4 = 0.25 = 25%.
The payback reciprocal overstates the true rate of return because it assumes that the annual cash flows will continue forever. It also assumes that the annual cash flows are identical in amount. Since these two conditions are unrealistic you should avoid the use of the payback reciprocal. Instead, you should compute the internal rate of return or the net present value because they will discount each of the actual cash amounts to reflect the time value of money.
