Reference no: EM131175294

Select one of the capital investment evaluation methods described in your text. Fully explain the capital evaluation method's strengths and weaknesses. Take a position and defend the use of your selected method. Be sure to use at least two scholarly sources to support your position. Your initial post should be 200-250 words.

The Payback Period Method

The payback period method is a "quick and dirty" evaluation of capital investment projects. It is likely that no major firm makes investment decisions based solely on the payback period, but many ask for the payback period as part of their analyses. The payback period method asks:

How fast do we get our initial cash investment back?

No ROR is given, only a time period. If annual cash flows are equal, the payback period is found as follows:

Net initial investment ÷ Annual net cash inflow = Payback period

If the investment is $120,000 and annual net cash inflow is $48,000, the payback period is 2.5 years. We do not know how long the project will last nor what cash flows exist after the 2.5 years. It might last 20 years or 20 days beyond the payback point.

If annual cash flows are uneven, the payback period is found by recovering the investment cost year by year. In the Clairmont Timepieces example:

In Year 3, the cost is totally recovered, using only $15,000 of Year 3's $20,000 (75 percent). The payback period is 2.75 years.

The payback method is viewed as a "bail-out" risk measure. How long do we need to stick with the project just to get our initial investment money back? It is used frequently in short-term projects where the impact of present values is not great. Such projects as efficiency improvements, cost reductions, and personnel savings are examples. Several major companies set an arbitrary payback period, such as six months, for certain types of cost-saving projects.

Using the Payback Reciprocal to Estimate the IRR. The payback period can be used to estimate a project's IRR, assuming a fairly high ROR (over 20 percent) and project life that is more than twice the payback period. For example, if a $40,000 investment earns $10,000 per year for an expected 12 years, the payback period is four years. The reciprocal of the payback period is 1 divided by 4 and gives an IRR estimate of 25 percent. From Table 2 for 12 years, the present value factor (payback period) of 4 indicates a rate of return of between 22 and 24 percent. The payback reciprocal will always overstate the IRR somewhat. If the project's life is very long, say 50 years, the payback reciprocal is an almost perfect estimator. (See the present value factor of 4.000 for 25 percent and 50 periods on Table 2.)

Ranking Projects. When the payback period is used to rank projects, the shortest payback period is best. Thus, all projects are listed from low to high. A firm's policy may say that no project with a payback period of over four years will be considered. This acts like a cutoff point. After that, projects would be selected until capital funds are exhausted. The major complaints about the payback period method are that it ignores:

1. The time value of money.
2. The cash flows beyond the payback point.

These are serious deficiencies, but the method is easily applied and can be a rough gauge of potential success.

References

Schneider, A. (2012), Managerial Accounting: Decision Making for the Service and Manufacturing sectors, San Diego, CA: Bridgepoint Education, Inc.