Payback Comparisons For Nova Products With 5-Year Max
P102payback Comparisonsnova Products Has A 5 Year Maximum Acceptable
P10–2 Payback comparisons Nova 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.
Determine the payback period for each machine.
Comment on the acceptability of the machines, assuming that they are independent projects.
Which machine should the firm accept? Why?
Do the machines in this problem illustrate any of the weaknesses of using payback? Discuss.
Paper For Above instruction
The investment decision-making process in firms often employs various capital budgeting techniques, among which the payback period is one of the simplest. This technique measures the time it takes for an investment to recoup its initial cost from the cash inflows generated. In this analysis, we evaluate two potential machines for Nova Products, considering their payback periods against the company’s maximum acceptable period of five years, along with an examination of their overall attractiveness and limitations of the payback method.
Calculating the Payback Periods
For the first machine, which requires an initial investment of $14,000 and provides annual after-tax cash inflows of $3,000, the payback period is calculated by dividing the initial investment by the annual cash inflows. That is, Payback Period = $14,000 / $3,000 ≈ 4.67 years. Since this period is less than the maximum acceptable duration of five years, this project qualifies on this basis.
The second machine requires an initial investment of $21,000 with annual cash inflows of $4,000. Applying the same formula, the payback period is $21,000 / $4,000 = 5.25 years. This exceeds the company's maximum acceptable payback period of five years, indicating that, on this criterion alone, it is less desirable.
Assessing Acceptability and Project Selection
Given the calculations, the first machine is acceptable within the company's criteria, whereas the second machine exceeds the maximum payback period. Assuming independence of these projects, the firm should accept the first machine based on the payback criterion, as it recovers the initial investment within the acceptable timeframe. The second machine, despite generating higher total cash flows over its lifetime, fails the payback test and might be rejected unless other criteria such as net present value (NPV) or internal rate of return (IRR) are considered.
Limitations of the Payback Method
The payback method, while straightforward, possesses notable weaknesses highlighted by this example. Firstly, it ignores cash flows occurring after the payback period, potentially undervaluing projects with longer-term benefits. The second machine, with its longer lifespan and higher total cash inflows, might be more profitable in the long run, yet it is rejected based solely on payback criteria.
Additionally, the payback approach neglects the time value of money, meaning it treats a dollar received in year one equivalently to a dollar in year twenty. This oversight can lead to suboptimal investment decisions. It also does not account for risk or the cost of capital, factors essential for comprehensive evaluation.
Conclusion
In conclusion, the payback period offers a simplistic and quick assessment but fails to capture the full profitability or the time value of money. In this scenario, the first machine aligns with the company's payback criterion, but reliance solely on payback could result in rejecting potentially beneficial investments like the second machine. Hence, firms should complement payback analysis with other techniques such as NPV and IRR for more informed decision-making.
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