Payback Comparisons: Nova Products Have 5-Year Maximum

P10–2 Payback comparisons Nova Products has a 5-year maximum acceptable

Nova Products is evaluating two alternative machines for purchase, each with different initial investments, cash inflows, and operational durations. The firm’s criterion is a maximum acceptable payback period of five years. The first machine requires an initial investment of $14,000 and yields annual after-tax cash inflows of $3,000 for seven years. The second machine requires a larger initial investment of $21,000 but provides annual after-tax cash inflows of $4,000 over twenty years. The assignment involves calculating the payback periods, analyzing the acceptability of each machine based on the company's criterion, recommending a purchase decision, and discussing potential weaknesses of using payback as the sole investment criterion.

Paper For Above instruction

The evaluation of investment projects is critical for firms aiming to optimize resource allocation and maximize shareholder value. Among various techniques to appraise capital investments, the payback period method remains popular due to its simplicity and focus on liquidity. However, it is essential to understand its application, limitations, and suitability in decision-making processes. This paper discusses the calculation of payback periods for two equipment options, assesses their acceptability based on the maximum five-year criterion, and critically examines the effectiveness of using payback as an exclusive investment measure.

Introduction

The payback period is one of the earliest and simplest capital budgeting methods, primarily used to determine how long it takes for an investment to recover its initial cost through cash inflows. The appeal of this method lies in its straightforwardness, providing managers with a quick estimate of investment liquidity. Nonetheless, its limitations include neglecting the time value of money, cash flows occurring after the payback period, and profitability considerations. Therefore, while useful for initial screening, reliance solely on payback can be misleading, especially for long-term projects with substantial later cash flows.

Calculations of Payback Period

For the first machine, with an initial investment of $14,000 and annual cash inflows of $3,000, the payback period is calculated by dividing the initial investment by annual cash inflows:

Payback period = $14,000 / $3,000 ≈ 4.67 years

This indicates that the machine will recover its cost in approximately 4 years and 8 months, which satisfies the company's maximum acceptable period of five years.

For the second machine, with an initial investment of $21,000 and annual cash inflows of $4,000, the payback period is:

Payback period = $21,000 / $4,000 = 5.25 years

This exceeds the five-year maximum, implying that the second machine does not meet the company's payback criterion.

Acceptability Analysis

Based on the calculated payback periods, the first machine is acceptable as it recovers the investment in under five years. Conversely, the second machine's payback period surpasses the threshold, rendering it unacceptable according to the company’s policy. However, this assessment solely based on payback ignores other crucial factors like total cash inflows, profitability, and the project's overall value contribution.

Recommendation

Given that the first machine meets the payback criterion and involves a lower initial investment, it aligns with the company's liquidity preferences and risk appetite. Nonetheless, decision-makers should not solely rely on payback; considering metrics such as net present value (NPV) or internal rate of return (IRR) would provide a more comprehensive evaluation. Therefore, the recommendation would favor the first machine in light of the payback analysis, but with a prudent approach to consider other value metrics before final approval.

Weaknesses of the Payback Method

The example illustrates several weaknesses associated with using payback period exclusively. Firstly, it ignores the time value of money, which can misrepresent the true profitability of long-term projects. For instance, cash flows occurring in the later years are undervalued or disregarded. Secondly, it does not measure overall profitability, only the speed of recovering initial investment, potentially dismissing highly profitable projects with longer payback periods. Thirdly, payback fails to account for cash flows beyond the payback point, missing significant value that can influence project decisions. Lastly, the rigid threshold (e.g., five years) may be arbitrary and unsuitable for different projects or industries.

Conclusion

While the payback period is a useful initial screening tool due to its simplicity, reliance solely on this measure can lead to suboptimal investment decisions. The first machine is preferable based on the payback criterion, but comprehensive evaluation using additional financial metrics is recommended to ensure optimal capital allocation. Firms should recognize the limitations of payback and integrate other tools like NPV and IRR for more balanced decision-making.

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