Example 1:
Delta Company is planning to purchase a machine known as machine X. Machine X
would cost $25,000 and would have a useful life of 10 years with zero salvage
value. The expected annual cash inflow of the machine is $10,000.
Required: Compute payback period of machine X and conclude whether or not the
machine would be purchased if the maximum desired payback period of Delta
company is 3 years.
Solution:
Since the annual cash inflow is even in this project, we can simply divide the initial
investment by the annual cash inflow to compute the payback period. It is shown
below:
Payback period = $25,000/$10,000
= 2.5 years
According to payback period analysis, the purchase of machine X is desirable
because its payback period is 2.5 years which is shorter than the maximum payback
period of the company.
Advantages and disadvantages of payback method:
Some advantages and disadvantages of payback method are given below:
Advantages:
1. An investment project with a short payback period promises a quick inflow of
cash. It is therefore, a useful capital budgeting method for cash poor firms.
2. A project with short payback period can improve the liquidity position of the
business quickly. The payback period is important for the firms for which
liquidity is very important.
3. An investment with short payback period makes the funds available soon to
invest in another project.
4. A short payback period reduces the risk of loss caused by changing economic
conditions and other unavoidable reasons.
5. Payback period is very easy to compute and apply.
Disadvantages:
1. The payback method does not take into account the time value of money.
2. It does not consider the useful life of the assets and inflow of cash that the
project may generate after its payback period. For example, two projects,
project A and project B, both require an initial investment of $5,000. Project A
generates an annual cash inflow of $1,000 for 5 years whereas project B also
generates an annual cash inflow of $1,000 but for 7 years. It is clear that the
project B is going to be more profitable than project A, but according to
payback method, both the projects are equally desirable, because both have
a payback period of 5 years (= $5,000/$1,000).