This page covers CPA practice questions covering payback method. The payback period is the length of time that it takes for a project to recover its initial cost.
The payback method of evaluating capital budgeting projects focuses on the payback period. The payback period is the length of time that it takes for a project to recover its initial cost from the net cash inflows that it generates. This period is sometimes referred to as “the time that it takes for an investment to pay for itself.” The basic premise of the payback method is that the more quickly the cost of an investment can be recovered, the more desirable is the investment.
The payback period is expressed in years. When the annual net cash inflow is the same every year, the following formula can be used to compute the payback period
Payback period = investment required/annual net cash inflow.
Example A: York Company needs a new milling machine. The company is considering two machines: machine A and machine B. Machine A costs $15,000, has a useful life of ten years, and will reduce operating costs by $5,000 per year. Machine B costs only $12,000, will also reduce operating costs by $5,000 per year, but has a useful life of only five years.
Which machine should be purchased according to the payback method?
Machine A: 3 years
Machine B: 2.4 years
Evaluation of the Payback Method
The payback method is not a true measure of the profitability of an investment. Rather, it simply tells a manager how many years are required to recover the original investment. Unfortunately, a shorter payback period does not always mean that one investment is more desirable than another.
To illustrate, refer back to Example A on the previous page. Machine B has a shorter payback period than machine A, but it has a useful life of only 5 years rather than 10 years for machine A. Machine B would have to be purchased twice—once immediately and then again after the fifth year—to provide the same service as just one machine A. Under these circumstances, machine A would probably be a better investment than machine B, even though machine B has a shorter payback period. Unfortunately, the payback method ignores all cash flows that occur after the payback period.
On the other hand, under certain conditions the payback method can be very useful. For one thing, it can help identify which investment proposals are in the “ballpark.” That is, it can be used as a screening tool to help answer the question, “Should I consider this proposal further?” If a proposal doesn’t provide a payback within some specified period, then there may be no need to consider it further. In addition, the payback period is often important to new companies that are “cash poor.” When a company is cash poor, a project with a short payback period but a low rate of return might be preferred over another project with a high rate of return but a long payback period. The reason is that the company may simply need a faster return of its cash investment. And finally, the payback method is sometimes used in industries where products become obsolete very rapidly—such as consumer electronics. Because products may last only a year or two, the payback period on investments must be very short.