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such a short payback period, the EXAMPLE In Practice Limits of Payback Analysis manufacturing effectiveness.
Whereas Japanese managers
will invest $1 million to replace
one job, U.S. managers invest
about $250,000. At prevailing
wage rates, the Japanese
accept a 5- to 6-year payback,
compared to a period of 3 to 4
years in the United States.
These differences underscore
the linkages that exist between
a firm’s operations and finance. pace of automation has been very
slow. For example, the payback
period for materials transport
automation—moving material from
one point to another with minimum
labor—averages 5 to 6 years.
This situation underscores
a major limitation of payback
period analysis. Companies
that rely only on the payback
period may not give fair consideration to technology that can
greatly improve their long-term Rashid Company, a software developer, has two investment opportunities, X and
Y. Data for X and Y are given in Table 9.3. The payback period for project X is 2
years; for project Y it is 3 years. Strict adherence to the payback approach suggests that project X is preferable to project Y. However, if we look beyond the
payback period, we see that project X returns only an additional $1,200 ($1,000
in year 3 $100 in year 4 $100 in year 5), whereas project Y returns an additional $7,000 ($4,000 in year 4 $3,000 in year 5). On the basis of this information, project Y appears preferable to X. The payback approach ignored the cash
inflows occurring after the end of the payback period.4
TABLE 9.3 Calculation of the
Payback Period for
Project X Initial investment
Year Project Y $10,000 $10,000 Operating cash inflows 1 $5,000 $3,000 2 5,000 4,000 3 1,000 3,000 4 100 4,000 5 100 3,000 2 years 3 years Payback period 4. To get around this weakness, some analysts add a desired dollar return to the initial investment and then calculate
the payback period for the increased amount. For example, if the analyst wished to pay back the initial investment plus
20% for projects X and Y in Table 9.3, the amount to be recovered would be $12,000 [$10,000 (0.20 $10,000)].
For project X, the payback period would be infinite because the $12,000 would never be recovered; for project Y, the
payback period would be 3.50 years [3 years ($2,000 $4,000) years]. Clearly, project Y would be preferred. CHAPTER 9 Capital Budgeting Techniques 401 Review Questions
9–3 LG3 What is the payback period? How is it calculated?
What weaknesses are commonly associated with the use of the payback
period to evaluate a proposed investment? 9.3 Net Present Value (NPV) net present value (NPV)
A sophisticated capital budgeting technique; found by subtracting a project’s initial investment
from the present value of its cash
inflows discounted at a rate
equal to the firm’s cost of capital. Because net present value (NPV) gives explicit consideration to the time value of
money, it is considered a sophisticated capital budgeting technique. All such techniques in one way or another discount the...
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