Therefore the shorter the payback period the lower

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Unformatted text preview: shorter the payback period, the lower the firm’s exposure to such risk. CHAPTER 9 Capital Budgeting Techniques 399 The major weakness of the payback period is that the appropriate payback period is merely a subjectively determined number. It cannot be specified in light of the wealth maximization goal because it is not based on discounting cash flows to determine whether they add to the firm’s value. Instead, the appropriate payback period is simply the maximum acceptable period of time over which management decides that a project’s cash flows must break even (that is, just equal the initial investment). A second weakness is that this approach fails to take fully into account the time factor in the value of money.3 This weakness can be illustrated by an example. EXAMPLE DeYarman Enterprises, a small medical appliance manufacturer, is considering two mutually exclusive projects, which it has named projects Gold and Silver. The firm uses only the payback period to choose projects. The relevant cash flows and payback period for each project are given in Table 9.2. Both projects have 3year payback periods, which would suggest that they are equally desirable. But comparison of the pattern of cash inflows over the first 3 years shows that more of the $50,000 initial investment in project Silver is recovered sooner than is recovered for project Gold. For example, in year 1, $40,000 of the $50,000 invested in project Silver is recovered, whereas only $5,000 of the $50,000 investment in project Gold is recovered. Given the time value of money, project Silver would clearly be preferred over project Gold, in spite of the fact that they both have identical 3-year payback periods. The payback approach does not fully account for the time value of money, which, if recognized, would cause project Silver to be preferred over project Gold. A third weakness of payback is its failure to recognize cash flows that occur after the payback period. TABLE 9.2 Relevant Cash Flows and Payback Periods for DeYarman Enterprises’ Projects Project Gold Initial investment Year Project Silver $50,000 $50,000 Operating cash inflows 1 $ 5,000 $40,000 2 5,000 2,000 3 40,000 8,000 4 10,000 10,000 5 10,000 10,000 Payback period 3 years 3 years 3. To consider differences in timing explicitly in applying the payback method, the present value payback period is sometimes used. It is found by first calculating the present value of the cash inflows at the appropriate discount rate and then finding the payback period by using the present value of the cash inflows. 400 PART 3 Long-Term Investment Decisions FOCUS ON PRACTICE The high labor component of U.S. textile manufacturers creates a cost disadvantage that makes it hard for them to compete in global markets. They lag behind other U.S. industries and foreign textile producers in terms of plant automation. One key hurdle is payback period. The industry standard for capital expenditure projects for machinery is 3 years. Because few major automation projects...
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