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Because few major automation projects have such a

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Unformatted text preview: have 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 Rashid Company’s Two Alternative Investment Projects 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 9–2 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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