Payback comparisons Nova Products has a 4-year maximum acceptable payback period

Question

Payback comparisons Nova Products has a 4-year maximum acceptable payback period. The firm is considering the purchase of a new machine and must choose between two alternatives. The first machine requires an initial investment of $10,000 and generates annual after-tax cash inflows of $2,000 for each of the next 8 years. The second machine requires an initial investment of $29,000 and provides an annual cash inflow after taxes of S7,000 for 26 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? a. The payback period for the first machine isyears. (Round to two decimal places.) The payback period for the second machine is years. (Round to two decimal places.) b. Is the first machine acceptable? (Select the best answer below.) O No O Yes Is the second machine acceptable? (Select the best answer below.) O No O Yes

Explanation / Answer

Machine 1:

Cumualative cash flow for year 0 = -10,000

Cumulative cash flow for year 1 = -10,000 + 2,000 = -8,000

Cumulative cash flow for year 2 = -8,000 + 2,000 = -6,000

Cumulative cash flow for year 3 = -6,000 + 2,000 = -4,000

Cumulative cash flow for year 4 = -4,000 + 2,000 = -2,000

  Cumulative cash flow for year 5 = -2,000 + 2,000 = 0

Payback period is 5 years

Machine 2:

Cumualative cash flow for year 0 = -29,000

Cumulative cash flow for year 1 = -29,000 + 7,000 = -22,000

Cumulative cash flow for year 2 = -22,000 + 7,000 = -15,000

Cumulative cash flow for year 3 = -15,000 + 7,000 = -8,000

Cumulative cash flow for year 4 = -8,000 + 7,000 = -1,000

  Cumulative cash flow for year 5 = -1,000 + 7,000 = 6,000

1000 / 7000 = 0.14

Payback period = 4 + 0.14 = 4.14 years

First machine is NOT acceptable as it has a payback period of more than 4 years

Second machine os NOT acceptable as it has a payback period of more than 4 years

Machine 2 has returns that last 26 years while machine 1 has only 8 years of returns. Payback cannot consider this difference; it ignores all cash inflows beyond the payback period

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