{"id":102,"date":"2015-06-25T22:02:13","date_gmt":"2015-06-25T22:02:13","guid":{"rendered":"https:\/\/courses.candelalearning.com\/managacct2x10xmaster\/?post_type=chapter&p=102"},"modified":"2016-01-01T14:29:36","modified_gmt":"2016-01-01T14:29:36","slug":"methods-for-evaluation-of-capital-investment-proposals","status":"publish","type":"chapter","link":"https:\/\/courses.lumenlearning.com\/suny-managacct\/chapter\/methods-for-evaluation-of-capital-investment-proposals\/","title":{"raw":"11.2 Short Term Business Decisions","rendered":"11.2 Short Term Business Decisions"},"content":{"raw":"
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Project selection: Payback period<\/strong><\/h4>\r\nThe payback period<\/strong> is the time it takes for the cumulative sum of the annual net cash inflows from a project to equal the initial net cash outlay. In effect, the payback period answers the question: How long will it take the capital project to recover, or pay back, the initial investment?\r\n\r\nhttps:\/\/youtu.be\/YX4NoZN8YWU\r\n\r\nIf the net cash inflows each year are a constant amount, the formula for the payback period is:\r\n\r\n\r\n\r\n\r\n
Payback period =\u00a0<\/strong><\/td>\r\nInitial cash outlay<\/span><\/td>\r\n<\/tr>\r\n
Annual net cash inflow (benefit)<\/td>\r\n<\/tr>\r\n<\/tbody>\r\n<\/table>\r\nFor the two assets discussed in the previous section, you can compute the payback period as follows. The purchase of the $120,000 equipment creates an annual net cash inflow after taxes of $18,200, so the payback period is 6.6 years, computed as follows:\r\n\r\n\r\n\r\n\r\n
Payback period =<\/td>\r\nInitial cash outlay<\/span><\/td>\r\n\u00a0= 120,000<\/span><\/td>\r\n\u00a0= 6.6 years (rounded)<\/td>\r\n<\/tr>\r\n
Annual net cash inflow (benefit)<\/td>\r\n18,200<\/td>\r\n<\/tr>\r\n<\/tbody>\r\n<\/table>\r\nThe payback period for the replacement machine with a $28,000 cash outflow in the first year and an annual net cash inflow of $2,600, is 10.8 years, computed as follows:\r\n\r\n\r\n\r\n\r\n
Payback period =<\/td>\r\nInitial cash outlay<\/span><\/td>\r\n\u00a0= 28,000<\/span><\/td>\r\n\u00a0= 10.8\u00a0 years (rounded)<\/td>\r\n<\/tr>\r\n
Annual net cash inflow (benefit)<\/td>\r\n2,600<\/td>\r\n<\/tr>\r\n<\/tbody>\r\n<\/table>\r\nRemember that the payback period indicates how long it will take the machine to pay for itself. The replacement machine being considered has a payback period of 10.8 years but a useful life of only 8 years. Therefore, because the investment cannot pay for itself within its useful life, the company should not purchase a new machine to replace the two old machines.\r\n\r\nIn each of the previous examples, the projected net cash inflow per year was uniform. When the annual returns are uneven, companies use a cumulative calculation to determine the payback period, as shown in the following situation.\r\n\r\nNeil Company is considering a capital investment project that costs $40,000 and is expected to last 10 years. The projected annual net cash inflows are:\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n
Year<\/strong><\/td>\r\nInvestment<\/strong><\/td>\r\nAnnual net cash inflow<\/strong><\/td>\r\nCumulative net cash inflows<\/strong><\/td>\r\n<\/tr>\r\n
0<\/td>\r\n$ 40,000<\/td>\r\n\u00a0-----<\/td>\r\n---<\/td>\r\n<\/tr>\r\n
1<\/td>\r\n---<\/td>\r\n$ 8,00<\/td>\r\n$ 8,000<\/td>\r\n<\/tr>\r\n
2<\/td>\r\n---<\/td>\r\n6,000<\/td>\r\n14,000<\/td>\r\n<\/tr>\r\n
3<\/td>\r\n---<\/td>\r\n7,000<\/td>\r\n21,000<\/td>\r\n<\/tr>\r\n
4<\/td>\r\n----<\/td>\r\n5,000<\/td>\r\n26,000<\/td>\r\n<\/tr>\r\n
5<\/td>\r\n---<\/td>\r\n8,000<\/td>\r\n34,000<\/td>\r\n<\/tr>\r\n
6<\/td>\r\n---<\/td>\r\n6,000<\/td>\r\n40,000<\/td>\r\n<\/tr>\r\n
7<\/td>\r\n---<\/td>\r\n3,000<\/td>\r\n43,000<\/td>\r\n<\/tr>\r\n
8<\/td>\r\n---<\/td>\r\n2,000<\/td>\r\n45,000<\/td>\r\n<\/tr>\r\n
10<\/td>\r\n---<\/td>\r\n1,000<\/td>\r\n49,000<\/td>\r\n<\/tr>\r\n<\/tbody>\r\n<\/table>\r\nThe payback period in this example is six years, the time it takes to recover the $40,000 original investment as show in the cumulative net cash inflows of year 6.\r\n\r\nWhen using payback period analysis to evaluate investment proposals, management may choose one of these rules to decide on project selection:\r\n