Chapter 24: Payback Period

Capital Budgeting Overview Capital budgeting involves evaluating potential long-term investments, such as purchasing new equipment, expanding facilities, or acquiring another company. The primary goal is to choose investments that yield a satisfactory return. Below are key points covered in the overview: 1. Capital Budgeting Process: o A proposal for investment is initiated by a manager. o A capital budget committee evaluates and recommends approval or rejection. o The final decision is made by the board of directors or senior managers. 2. Investment Risks: o Predicting future outcomes is challenging. o Significant financial resources are involved. o Investments require long-term commitment. o Decisions are difficult to reverse. 3. Capital Investment Cash Flows: o Investments involve initial cash outflows (e.g., buying a machine) and future cash inflows (e.g., sales revenue generated by the asset). o Some assets may have a salvage value at the end of their useful lives, contributing an additional cash inflow. o Evaluation of investments focuses on net cash flows, which is the difference between cash inflows and outflows. Payback Period for Investment Decisions The Payback Period (PBP) is a method to assess investment risk by calculating the time required to recover the initial investment from net cash flows. Key Concepts of Payback Period 1. Formula for Equal Cash Flows: Payback Period=Initial InvestmentAnnual Net Cash Flow If cash flows are consistent each year, the payback period is calculated directly using this formula. 2. Unequal Cash Flows: o The payback period is calculated by summing cumulative net cash flows each year until the initial investment is fully recovered. o If the recovery occurs partway through a year, the portion is estimated using a fraction of the net cash flow for that year. o Example with Equal Cash Flows • FasTrac Example: A $16,000 machine investment generates a consistent annual net cash flow of $4,000. The payback period is: Payback Period=$16,000$4,000=4 years Example with Unequal Cash Flows • FasTrac’s Investment: o Initial investment: $16,000. o Net cash flows over 8 years: $2,000, $4,000, $6,000, $2,000, $4,000. o Cumulative cash flows indicate recovery at 4.5 years because the cumulative cash flow changes from negative to positive midway through Year 5. Evaluating the Payback Period 1. Strengths: o Uses cash flows, not accounting profits. o Simple and quick to calculate. 2. Weaknesses: o Ignores the time value of money. o Does not consider cash flows occurring after the payback period, potentially leading to suboptimal choices. Application Example Need-to-Know 24-1: • • Scenario: A company is evaluating equipment costing $75,000 with varying annual net cash flows: o Year 1: $30,000 o Year 2: $25,000 o Year 3: $18,000 o Year 4: $10,000 o Year 5: $5,000 Payback Period Calculation: 1. Cumulative Cash Flows:  End of Year 1: $30,000  End of Year 2: $30,000 + $25,000 = $55,000  End of Year 3: $55,000 + $18,000 = $73,000  End of Year 4: $73,000 + $10,000 = $83,000 2. The initial $75,000 investment is paid back during Year 4. 3. Calculation for partial recovery: Fraction of Year 4=$2,000$10,000=0.2 4. Total Payback Period: 3 years + 0.2 of Year 4 = 3.2 years. Conclusion The Payback Period method provides a quick estimate of the time needed to recover an investment, making it a valuable first step in evaluating long-term projects. However, for a comprehensive assessment, managers should use other methods (like Net Present Value or Internal Rate of Return) that consider the time value of money and long-term cash flows.