The Dammon Corp. has the following investment opportunities: Machine A ($15,000)

Question

The Dammon Corp. has the following investment opportunities:

Machine A ($15,000) Inflow Machine B ($22,500) Inflows Machine C ($37,500) Inflows
Year 1 $6,000 Year 1 $12,000 Year 1 $-0-
Year 2 9,000 Year 2 12,000 Year 2 30,000
Year 3 3,000 Year 3 10,500 Year 3 30,000
Year 4 -0- Year 4 10,500 Year 4 15,000
Year 5 -0- Year 5 -0- Year 5 15,000


Under the payback method and assuming these machines are mutually exclusive, which machine(s) would Dammon Corp. choose?


1) Machine A

2) Machine B

3) Machine C

4) Machine A and B

Explanation / Answer

If we are using the payback period method, we want to choose the opportunities that have the shortest payback period but the highest payoff. Machine A The cost is (15,000) and we will get that back in two years ($6,000 + $9,000). You would only gain a net profit of $3,000. Machine B The cost is (22,500) and we will get that back in: Year 1: $12,000 - 1 year Year 2: $22,500-$12,000 = 10,500. Divide this by the total and get the portion of the year it takes to get it. = .875 years Machine B takes 1.875 years to payback and has a 5-year net profit of $22,500. Just looking at the opportunity for Machine C, we see that we don't start getting paid back until year 2 and that we won't receive full payback until a little after the second year starts. This does, however, get a net profit of $52,500, which is the best investment in the 5-year period. I would go with Machine C for that reason even though it is the longest payback period.

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