Question

Derek has two choices for a heat-loss prevention system for the shipping doors at Kirkland Manufacturing. He can isolate the shipping department from the rest of the plant, or he can curtain off each shipping door separately. Isolation consists of building a permanent wall around the shipping area. It will cost $60 000 and will save $10 000 in heating costs per year. Plastic curtains around each shipping door will have a total cost of about $5000, but will have to be replaced about once every two years. Savings in heating costs for installing the curtains will be about $3000 per year. Use the payback period method to determine which alternative is better. Comment on the use of the payback period for making this decision.

Answer 1

For the first case.

Initial Investment = $60,000

Net Cash inflow = $10,000

Pay Back Period = Initial Investment / Net cash inflow

= 60,000 / 10,000 = 6

For the second case.

Initial Investment = $ 5000

Net Cash inflow = $ 3000

Pay back period = Initial Investment / Net cash inflow

= 5000 / 3000 = 1.67

The correct decision should be to invest in a project which has a shorter pay back period. So, the second alternative is better. A higher pay back period refers to higher risk and hence a higher return. Though, it is logical to accept the project if the risk is low and hence the pay back period.