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# The decision criteria when the payback period is used

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Unformatted text preview: n the payback period is used to make accept–reject decisions, the decision criteria are as follows: • If the payback period is less than the maximum acceptable payback period, accept the project. • If the payback period is greater than the maximum acceptable payback period, reject the project. The length of the maximum acceptable payback period is determined by management. This value is set subjectively on the basis of a number of factors, including the type of project (expansion, replacement, renewal), the perceived risk of the project, and the perceived relationship between the payback period and the share value. It is simply a value that management feels, on average, will result in valuecreating investment decisions. EXAMPLE Hint In all three of the decision methods presented in this text, the relevant data are after-tax cash flows. Accounting profit is used only to help determine the after-tax cash flow. Hint The payback period indicates to firms taking on projects of high risk how quickly they can recover their investment. In addition, it tells firms with limited sources of capital how quickly the funds invested in a given project will become available for future projects. We can calculate the payback period for Bennett Company’s projects A and B using the data in Table 9.1. For project A, which is an annuity, the payback period is 3.0 years (\$42,000 initial investment \$14,000 annual cash inflow). Because project B generates a mixed stream of cash inflows, the calculation of its payback period is not as clear-cut. In year 1, the firm will recover \$28,000 of its \$45,000 initial investment. By the end of year 2, \$40,000 (\$28,000 from year 1 \$12,000 from year 2) will have been recovered. At the end of year 3, \$50,000 will have been recovered. Only 50% of the year 3 cash inflow of \$10,000 is needed to complete the payback of the initial \$45,000. The payback period for project B is therefore 2.5 years (2 years 50% of year 3). If Bennett’s maximum acceptable payback period were 2.75 years, project A would be rejected and project B would be accepted. If the maximum payback were 2.25 years, both projects would be rejected. If the projects were being ranked, B would be preferred over A, because it has a shorter payback period. Pros and Cons of Payback Periods The payback period is widely used by large firms to evaluate small projects and by small firms to evaluate most projects. Its popularity results from its computational simplicity and intuitive appeal. It is also appealing in that it considers cash flows rather than accounting profits. By measuring how quickly the firm recovers its initial investment, the payback period also gives implicit consideration to the timing of cash flows and therefore to the time value of money. Because it can be viewed as a measure of risk exposure, many firms use the payback period as a decision criterion or as a supplement to other decision techniques. The longer the firm must wait to recover its invested funds, the greater the possibility of a calamity. Therefore, the...
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