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Chapter 26: Q10RQ (page 1463)

What is the decision rule for payback?

Short Answer

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Answer

The general rule is that investments with shorter payback periods are observed as more appropriate and preferable.

Step by step solution

01

Meaning of Payback

The payback period is used to compare projects in capital arrangements and evaluate the time it takes for the initial venture to recover in years. The payback period is the time it takes to recover the initial expense.

02

Decision rule for payback

The greater the risk, the longer the project's payback period. If two ventures with equal returns are commonly contradictory, the choice ought to be made to contribute to the project with the most limited payback period.

The payback period refers to the amount of time it takes for the initial investment in a project to be returned by future cash flows. The best project is the one that helps the company return its investment the quickest, and it is the one to which the company should devote its resources.

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Most popular questions from this chapter

Using IRR to make capital investment decisions

Refer to the data regarding Hawkins Products in Exercise E26-25. Compute the IRR of each project, and use this information to identify the better investment.

You are planning for a very early retirement. You would like to retire at age 40 and have enough money saved to be able to withdraw \(215,000 per year for the next 40 years (based on family history, you think you will live to age 80). You plan to save by making 10 equal annual installments (from age 30 to age 40) into a fairly risky investment fund that you expect will earn 10% per year. You will leave the money in this fund until it is completely depleted when you are 80 years old.

Requirements

1. How much money must you accumulate by retirement to make your plan work? (Hint:Find the present value of the \)215,000 withdrawals.)

2. How does this amount compare to the total amount you will withdraw from the investment during retirement? How can these numbers be so different?

What is the internal rate of return?

Congratulations! You have won a state lottery. The state lottery offers you the following (after-tax) payout options:

Option #1: \(12,000,000 after five years

Option #2: \)2,150,000 per year for five years

Option #3: $10,000,000 after three years

Assuming you can earn 6% on your funds, which option would you prefer?

Lockwood Company is considering a capital investment in machinery:

Initial investment $ 600,000

Residual value 50,000

Expected annual net cash inflows 100,000

Expected useful life 8 years

Required rate of return 12%

8. Calculate the payback.

9. Calculate the ARR. Round the percentage to two decimal places.

10. Based on your answers to the above questions, should Lockwood invest in the machinery?
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