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Chapter 4: Q9BP (page 255)

The Short-Line Railroad is considering a \(140,000 investment in either of two companies. The cash flows are as follows:

Year

Electric Co

Water works

1

\)85,000

$30,000

2

25,000

25,000

3

30,000

85,000

4-10

10,000

10,000

a. Using the payback method, what will the decision be?

b. Explain why the answer in part a can be misleading.

Short Answer

Expert verified

Answer

  1. Using the payback method, the business entity can select any available options because both have the same payback period.

  2. Answer in part (a) is misleading because if we consider the time value of money, the Electric company will be a more beneficial investment.

Step by step solution

01

Definition of Payback period

A metric used in the capital budgeting method that selects the investment based on the time taken by the investment to cover the amount of potential investment through cash inflows is known as the payback period.

02

Decision using the payback method

Year

Cash inflow for Electric Co

Accumulated cash inflow for Electric Co

Cash inflow for Water works

Water works

1

$85,000

$85,000

$30,000

$30,000

2

25,000

$110,000

25,000

$55,000

3

30,000

$140,000

85,000

$140,000

4-10

10,000


10,000


The payback period for Electric Co: 3 years

The payback period for Water works: 3 years

03

Answer in part a is misleading

The answer provided in part a is misleading because both alternatives reflect the same payback period and will be considered the same. But in the above case, an Electric company seems to be a more efficient investment because it provides higher cash flow in the initial years. At the same time, water work generates higher recovery in the 3rd year. The answer is misleading because the payback period does not consider the time value of money.

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