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
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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