This exercise illustrates the use of payback period method to evaluate a cost-cutting project.
LASANI Stone Crushing Company is considering to purchase a new machine. The cost of the machine is $360,000 and the life of the machine is 10 years. The machine will reduce annual costs by $75,000. The management uses payback period method to evaluate capital investments because the quick recovery of any capital investment is very important for the company.
Required: Compute the payback period for this proposal. Would the company purchase new machine if maximum desired payback period of the management is 4 years?
Computation of payback period:
The new machine would not bring any cash into the business but reduce the cost. It is therefore a cost-cutting project. In order to apply the payback period formula, we must treat the annual reduction in cost as similar to annual cash inflow. In case of a cost-cutting project, we just need to replace the “net annual cash inflow” in the denominator of the formula by the “net annual cost saving”.
Payback period = Investment required to purchase the machine/Net annual cost savings
= 4.8 years
The initial investment of $360,000 would be recovered in 4.8 years by saving $75,000 in annual cost.
The payback period of the machine is 4.8 years which is longer than the maximum desired payback period of the company. If the payback period is the only metric to consider for this purchase decision, the machine would not be acquired.