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 The company can replace an existing, outdated machine with one of two technologically advanced machines. One replacement machine would cost $72,000. Management estimates that it 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 a. Determine the payback period for each investment alternative and identify which replacemert 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 is the period within which the initial investment of the machines is recovered by the cash inflows from the machines.
In case of equal annual cash inflows, payback period is computed as -
Payback period (in years) = Initial Investment / Yearly Cash Inflows
The initial investment in our current case is the cost of the machine. The cash inflows are the reduction in cash outflows for manufacturing expenses or we can say savings in manufacturing expenses. The machine which recovers the money earlier or whose payback period is less will be considered.
Machine I
Initial Investment = $72000
Annual cash inflows = $30000
Payback period = $72000 / $30000 = 2.4 years
Machine II
Initial Investment = $75600
Annual cash inflows = $27000
Payback period = $75600 / $27000 = 2.8 years
Since, payback period of Machine I is less than Machine II, the company should buy Machine I.
b) i) First and foremost, this method does not consider the time value of money which is of utmost importance while valuing proposals.
ii) Cost of capital is a strong basis for investment decisions, which is also ignored by this method. The NPV of machine I may be negative at the cost of capital, but it is chosen due to less payback period.
iii) In this method, only the payback of original investment is considered and any cash inflows arising beyong the payback period are not considered (like salvage value in our question). The objective of any business firm to invest money in capital projects is not only to get the investment back but to also earn profits.
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