Analyze capital investment Because cash is an essential measure of a business’s health, many managers esti- proposals using the payback

LO 5 Analyze capital investment Because cash is an essential measure of a business’s health, many managers esti- proposals using the payback

mate the cash flow that an investment will generate. Their goal is to determine period method and the account- the minimum time it will take to recover the initial investment. If two investment

ing rate-of-return method. alternatives are being studied, management should choose the investment that pays back its initial cost in the shorter time. That period of time is known as the payback period, and the method of evaluation is called the payback period method. Although the payback period method is simple to use, its use has declined because it does not consider the time value of money.

Payback Calculation The payback period is computed as follows: Study Note The payback period method

Payback Period ⫽ Cost of Investment ______________________ Annual Net Cash Inflows

measures the estimated length of time necessary to recover in

To apply the payback period method, suppose that Neighborhood Commu- cash the cost of an investment.

nications is interested in purchasing a new server that costs $51,000 and has a residual value of $3,000. Assume that estimates for the proposal include rev- enue increases of $17,900 a year and operating cost increases of $11,696 a year (including depreciation and taxes). To evaluate this proposed capital investment, use the following steps:

Step 1. Determine the cost of the investment. In the example, it is $51,000. Step 2. Determine the annual net cash inflows, which are the annual cash rev-

enues minus the cash expenses. 씰 Eliminate the effects of all noncash revenue and expense items

included in the analysis of net income to determine cash revenues and cash expenses.

씰 In this case, the only noncash expense or revenue is machine deprecia- tion. To eliminate it from operating expenses, you must first calculate depreciation expense. To calculate this amount, you must know the asset’s life and the depreciation method. Suppose that Neighborhood Communications uses the straight-line method of depreciation, and the new server will have a ten-year service life. The annual deprecia- tion is computed using this information and the facts given earlier, as follows:

Annual Depreciation ⫽ Cost ⫺ Residual Value ____________________ Years

10 Years ⫽ $4,800 per Year

CHAPTER 25 Capital Investment Analysis

S Step 3. Compute the payback period.

Study Note

In computing the payback Payback Period ⫽ ____________________________ Cost of Machine

Cash Revenue ⫺ Cash Expenses period, depreciation is omitted

because it is a noncash expense. ⫽ ____________________________ $17,900 ⫺ ($11,696 ⫺ $4,800)

*Rounded. If the company’s desired payback period is five years or less, this proposal would

be approved. Unequal Annual Net Cash Inflows If a proposed capital investment has

unequal annual net cash inflows, the payback period is determined by subtracting each annual amount (in chronological order) from the cost of the capital facility. When a zero balance is reached, the payback period has been determined. This will often occur in the middle of a year. The portion of the final year is computed by dividing the amount needed to reach zero (the unrecovered portion of the investment) by the entire year’s estimated cash inflow. The Review Problem in this chapter illustrates that process.

Advantages and Disadvantages The payback period method is widely used because it is easy to compute and understand. It is especially useful in areas in which technology changes rapidly, such as in Internet companies, and when risk is high, such as when investing in emerging countries. However, the disad- vantages of this approach far outweigh its advantages. First, the payback period method does not measure profitability. Second, it ignores differences in the pres- ent values of cash flows from different periods; thus, it does not adjust cash flows for the time value of money. Finally, the payback period method emphasizes the time it takes to recover the investment rather than the long-term return on the investment. It ignores all future cash flows after the payback period is reached.