GE Products has a 5-year maximum acceptable payback period. The firm is consider
ID: 2668770 • Letter: G
Question
GE 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 the problem illustrate any of the weaknesses of using payback? Discuss.
Explanation / Answer
Traditional PB period is The length of time required to recover the cost of an investment. a. PBP is Calculated as: COst of project/ANnual CFs Mach A : Payback period = 14000/3000 = 4.67 Yrs or 4.67*12 = 56 months Mach B : PB period = 21000/4000 = 5.25 Yrs or 5.25*12 = 63 months. b. Based on PB periods, Mach A is prefered as it gives quicker return of invested capital c. Firm should accept Mac A fo quicke return of capital. Also the econmic coditions may change over a period of time resulting in uncertain CFs. Hence faster return of capital is desired. d. There are two main problems with the payback period method: 1. It ignores any benefits that occur after the payback period and, therefore, does not measure profitability. 2. It ignores the time value of money. Because of these reasons, other methods of capital budgeting like net present value, internal rate of return or discounted cash flow are generally preferred.
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