Payback comparisons Nova Products has a 5-year maximum acceptable payback period
ID: 2383835 • Letter: P
Question
Payback comparisons Nova Products has a 5-year maximum acceptable payback period. The firm is considering the purchase of a new machine and must choose between two alternative ones. The first machine requires an initial investment of $14,000 and generates annual after-tax cash inflows of $3,000 for each of the next 7 years. The second machine requires an initial investment of $21,000 and provides an annual cash inflow after taxes of $4,000 for 20 years.
a. Determine the payback period for each machine.
b. Comment on the acceptability of the machines, assuming that they are independent projects.
c. Which machine should the firm accept? Why?
d. Do the machines in this problem illustrate any of the weaknesses of using payback? Discuss.
Explanation / Answer
Payback period = period up to which cummulative cash flow is negative + (negative cummulative cash flow /cash flow suceeding the above period)
Project A - Up to year 4 ,cash flow recovered = 3000 * 4 = 12,000
Payback period = 4 + (14,000-12,000)/3000
= 4 + 2000/3000
= 4 + .67
= 4.67 years
Project B= Cash flow recovered up to year 5 = 4000 * 5 = 20000
Payback period = 5 + (21000 -20000) /4000
= 5 + (1000/4000)
= 5 + .25
= 5.25 years
b)On the basis of Payback period ,Project A should be selected ,as it has lower payback period and is also within maximum acceptable payback period.back period.(4.67 < 5)
Project B should not be selected as the its payback recovery is not within maximum acceptable pay back period (5.25 >5 )
c)Machine A should be selected as it has lower payback period. than machine B.
D)The payback period ignores the life present value of cash flow and also the life of machine each project has.
so decision on the basis of payback period may not be accruate.
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