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Chapter 21: Problem 6

What is the payback method? What are its main strengths and weaknesses?

Short Answer

Expert verified
The payback method determines the time for an investment to recover its initial cost. Its strengths are simplicity and assessing risk, while weaknesses include ignoring the time value of money and cash flows after payback.

Step by step solution

01

Understanding the Payback Method

The payback method is a financial analysis tool used to determine the time required for an investment to pay off its initial cost. It calculates how long it will take to recover the initial investment from the cash flows generated by the project.
02

Strengths of the Payback Method

The main strengths of the payback method are its simplicity and ease of use. It provides a quick estimate of investment recovery time, which helps in initial screening of projects. It's also useful in assessing risk, as shorter payback periods typically indicate less uncertainty.
03

Weaknesses of the Payback Method

The payback method's weaknesses include its lack of consideration for the time value of money, meaning it doesn't account for the decreasing value of future cash flows. Additionally, it ignores any cash flows that occur after the payback period, potentially overlooking profitable projects. It also does not measure profitability or overall return.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Financial Analysis Tool
The payback method is widely recognized in the realm of financial analysis. It's a simple tool that investors and businesses use to gauge how quickly they can recover their initial investment. This method stands out due to its straightforward approach: it calculates the amount of time required for an investment to recoup its cost using the cash inflows it generates. The simplicity of this method makes it particularly appealing for those who need quick and easy insights.
  • It acts as an introductory screening tool for projects, allowing businesses to sift out less promising options early on.
  • Despite its simplicity, remember, it's just one tool in an extensive toolkit for financial analysis and does not provide the complete picture of an investment鈥檚 potential.
  • Using a combination of financial analysis tools ensures a comprehensive understanding of any project鈥檚 viability.
Investment Recovery
The payback method centers heavily on the concept of investment recovery. It's about understanding how long it will take to get back the money initially invested in a project. This focus provides a measure of reassurance to investors, particularly when short payback periods are crucial. Investors often prefer quicker investment returns to minimize exposure to risk.
  • Shorter payback periods reduce the uncertainty and potential risks associated with longer-term investments.
  • This approach helps prioritize projects by offering a clear timeline of when an investment is expected to break even.
  • However, the sole focus on how quickly the initial cost is recovered might overlook substantial long-term gains.
Time Value of Money
A critical shortcoming of the payback method is its disregard for the time value of money (TVM). The time value of money is a fundamental financial principle that portrays how the value of money decreases over time due to inflation and missed opportunities for earning potential. In simple terms, receiving a dollar today is more valuable than receiving a dollar tomorrow.
  • The payback method overlooks this concept by treating all money as if it holds the same value, regardless of time.
  • This limitation means it might not accurately represent the actual return on investment, especially when there are significant fluctuations in cash flows over the investment鈥檚 life.
  • Incorporating TVM considerations, such as discounted payback period methods, can offer a more complete analysis.
Project Screening
When it comes to project screening, the payback method is extremely useful in simplifying the initial selection process. It helps in quickly identifying which projects can recover their costs in the desired timeframe. This is especially significant for businesses or sectors where cash flow timing is critical.
  • It's efficient for filtering projects, especially when faced with multiple investment opportunities or limited resources.
  • Allows businesses to concentrate resources on those projects that promise swift capital recovery.
  • While valuable in project screening, it should serve as a preliminary evaluation tool, complemented with more detailed analysis before final decision making.

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Most popular questions from this chapter

Jack Garrett, a manager of the plate division for the Marble Top Manufacturing company, has the opportunity to expand the division by investing in additional machinery costing \(\$ 420,000 .\) He would depreciate the equipment using the straight-line method, and expects it to have no residual value. It has a useful life of seven years. The firm mandates a required aftertax rate of return of \(14 \%\) on investments. Jack estimates annual net cash inflows for this investment of \(\$ 125,000\) before taxes, and an investment in working capital of \(\$ 2,500 .\) Tax rate is \(35 \%\). 1\. Calculate the net present value of this investment. 2\. Calculate the accrual accounting rate of return on initial investment for this project. 3\. Should Jack accept the project? Will Jack accept the project if his bonus depends on achieving an accrual accounting rate of return of \(14 \% ?\) How can this conflict be resolved?

Bill Watts, president of Western Publications, accepts a capital budgeting project proposed by division X. This is the division in which the president spent his first 10 years with the company. 0 n the same day, the president rejects a capital budgeting project proposal from division Y. The manager of division Y is incensed. She believes that the division Y project has an internal rate of return at least 10 percentage points higher than the division X project. She comments, "What is the point of all our detailed DCF analysis? If Watts is panting over a project, he can arrange to have the proponents of that project massage the numbers so that it looks like a winner." What advice would you give the manager of division Y?

(CMA, adapted) New Bio Corporation is a rapidly growing biotech company that has a required rate of return of \(10 \%\). It plans to build a new facility in Santa Clara County. The building will take two years to complete. The building contractor offered New Bio a choice of three payment plans, as follows: \(\bullet\)Plan I Payment of \(\$ 100,000\) at the time of signing the contract and \(\$ 4,575,000\) upon completion of the building. The end of the second year is the completion date. \(\bullet\)Plan II Payment of \(\$ 1,550,000\) at the time of signing the contract and \(\$ 1,550,000\) at the end of each of the two succeeding years. \(\bullet\)Plan III Payment of \(\$ 200,000\) at the time of signing the contract and \(\$ 1,475,000\) at the end of each of the three succeeding years. 1\. Using the net present value method, calculate the comparative cost of each of the three payment plans being considered by New Bio. 2\. Which payment plan should New Bio choose? Explain. 3\. Discuss the financial factors, other than the cost of the plan, and the nonfinancial factors that should be considered in selecting an appropriate payment plan.

Describe the accrual accounting rate-of-return method. What are its main strengths and weaknesses?

Best-Cost Foods is considering replacing all 10 of its old cash registers with new ones. The old registers are fully depreciated and have no disposal value. The new registers cost \(\$ 749,700\) (in total). Because the new registers are more efficient than the old registers, Best-Cost will have annual incremental cash savings from using the new registers in the amount of \(\$ 160,000\) per year. The registers have a seven-year useful life and no terminal disposal value, and are depreciated using the straightline method. Best-Cost requires an \(8 \%\) real rate of return. 1\. Given the preceding information, what is the net present value of the project? Ignore taxes. 2\. Assume the \(\$ 160,000\) cost savings are in current real dollars, and the inflation rate is \(5.5 \% .\) Recalculate the NPV of the project. 3\. Based on your answers to requirements 1 and 2 , should Best-Cost buy the new cash registers? 4\. Now assume that the company's tax rate is \(30 \% .\) Calculate the NPV of the project assuming no inflation. 5\. Again assuming that the company faces a \(30 \%\) tax rate, calculate the NPV of the project under an inflation rate of \(5.5 \%\) 6\. Based on your answers to requirements 4 and 5 , should Best-Cost buy the new cash registers?
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