Exercise-7 (Payback period method- even cash flows)

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?

Solution:

Computation of payback period:

The cost saving of the machine is even (i.e., same amount of cost savings each year). The payback period can therefore be easily computed using payback period formula:

Payback period = Investment required to purchase the machine/Net annual cost savings
= $360,000/$75,000
= 4.8 years

Conclusion:

The payback period of the machine is 4.8 years which is longer than the desired payback period of the company. The machine would therefore not be purchased.