companies can delay paying taxes, the more cash they have available to invest. TECHNIQUES THAT IGNORE THE TIME VALUE OF MONEY LO 16-4 Evaluate investment opportunities using the payback method and the unadjusted rate of return. Lecture Video LO 16-4 Several techniques for evaluating capital investment proposals ignore the time value of money. Although these techniques are less accurate, they are quick and simple. When investments are small or the returns are expected within a short time, these techniques are likely to result in the same decisions that more sophisticated techniques produce. Payback Method The payback methodis simple to apply and easy to understand. It shows how long it will take to recover the initial cash outflow (the cost) of an investment. The formula for computing the payback period, measured in years, is as follows. To illustrate, assume Winston Cleaners can purchase a new ironing machine that will press shirts in half the time of the one currently used. The new machine costs $100,000 and will reduce labor cost by $40,000 per year over a four-year useful life. The payback period is computed as follows. Interpreting Payback Generally, investments with shorter payback periods are considered better. Because the payback method measures only investment recovery, not profitability, however, this conclusion can be invalid when considering investment alternatives. To illustrate, assume Winston Cleaners also has the opportunity to purchase a different machine that costs $100,000 and provides an annual labor savings of $40,000. However, the second machine will last for five instead of four years. The payback period is still 2.5 years ($100,000 ÷ $40,000), but the second machine is a better investment because it improves profitability by providing an additional year of cost savings. The payback analysis does not measure this difference between the alternatives.
Page 585 Unequal Cash Flows The preceding illustration assumed Winston's labor cost reduction saved the same amount of cash each year for the life of the new machine. The payback method requires adjustment when cash flow benefits are unequal. Suppose a company purchases a machine for $6,000. The machine will be used sporadically and is expected to provide incremental revenue over the next five years as follows. D Based on this cash inflow pattern, what is the payback period? There are two acceptable solutions. One accumulates D Page 586 Page 587 REAL-WORLD REPORTING PRACTICES In a study, researchers found that companies in the forest products industry use discounted cash flow techniques more frequently when the capital project being considered is a long-term timber investment. The use of techniques that ignore the time value of money increased when other shorter-term capital investment projects were being considered. Exhibit 16.8 shows the researchers' findings.
EXHIBIT 16.8 Forestry Industry Investments Data Source: J. Bailes, J. Nielsen, and S. Lawton, “How Forest Product Companies Analyze Capita l Budgets,” Management Accounting, October 1998, pp. 24 – 30. POSTAUDITS
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