Question

Nova Products has a 5​-year maximum acceptable payback period. The firm is considering the purchase of a new machine and must choose between two alternatives. The first machine requires an initial investment of $8,000 and generates annual​ after-tax cash inflows of $2,000 for each of the next 11 years. The second machine requires an initial investment of ​$19 ,000 and provides an annual cash inflow after taxes of ​$4 000 for 26 years.

. a. Determine the payback period for each machine

b. comment on the acceptability of the machines

c. which machine should the firm accept

d. do the machines in this problem illustrate any of the weaknesses of using payback

Answer 1

a. Payback period:

Machine A =8000/2000 =4 years

Machine B=19000/4000 =4.75 years

b. Both machines are acceptable, as they are within the acceptable limit of 5 years

c. Machine A will get accepted as the initial capital is recovered in just 4 years, which is better than the payback period of machine B.

d. The weakness of payback period is, it ignores any cash inflows that may occur after the payback period, if Machine A is accepted because of Payback period, then it will deprive the company of 26 years of cash inflow from Machine B.