Exercise 10-12B Determining the payback period The management team at Payne Manu
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Exercise 10-12B Determining the payback period The management team at Payne Manufacturing Company has decided to modernize the manufactur. ing facility. The company can replace an existing, outdated machine with one of two technologicali advanced machines. One replacement machine would cost $72,000. Manage would reduce cash outflows for manufacturing expenses by $30,000 per year. This machine is ex- pected to have an eight-year useful life and a $1,500 salvage value. The other replacement machine would cost $75,600 and would reduce annual cash outflows by an estimated $27,000. This machine has an expected 10-year useful life and a $7,500 salvage value. Required ment estimates that it a. Determine the payback period for each investment alternative and identify which replacement machine Payne should buy if it bases the decision on the payback approach. Discuss the shortcomings of the payback method of evaluating investment opportunities. b.Explanation / Answer
a) Payback period method helps to determine the number of years in which initial investment will be recovered from the cash inflows of the project. The formula to calculate payback period for an investment is as follows:
Payback period = Initial investment / Annual cash inflow
Given in problem that if new machine is purchased then it will reduce the cash outflow of manufacturing expenses. In other words, annual cash inflow will increase by the amount of reduced manufacturing expenses. Since, depreciation is a non-cash expense and therefore it is not deducted while calculating cash inflows. Also, Cost of machine is the initial investment of the machine.
Therefore, Machine 1 has initial investment of $72,000 while annual cash inflows are $30,000. Machine 2 has initial investment of $75,600 while annual cash inflows are $27,000. The payback period for both machines will be as follows:
Payback period (Machine 1) = $72,000/ $30,000
Payback period (Machine 1) = 2.4 years
Payback period (Machine 2) = $75,600 / $27,000
Payback period (Machine 2) = 2.8 years.
On basis of payback method, Machine 1 should be purchased by Payne manufacturing because its payback time is 2.4 years which is lesser that 2.8 years of machine 2. It means that Machine 1 will cover its costs earlier than machine 2.
b) There are various shortcomings of the payback period method while evaluating investment opportunities. Some of them are as follows:
1) This method does not consider the cash inflows of the project after payback period. Sometimes it happens that two projects may have same payback period but one project may have higher future cash inflows than other. But payback period method considers both projects same which is not correct.
2) It does not take into consideration the time value of money. It considers that a rupee received in first year is as equivalent as a rupee received in second year while it is not so. .
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