Payback Method

The Payback Method is a useful tool for determining the profitability of an investment by
assessing the time it takes to recoup the initial investment. This method suggests that
investments are more favorable if they generate a quick return on investment. The
payback period, measured in years, represents the duration required to recover the
invested funds. To calculate the payback period, simply divide the amount of money
invested by the annual earnings. This method provides a straightforward approach to
evaluate the viability of an investment.

Example G:
The company is in need of a new grinding machine. They have two options to choose
from: Machine A and Machine B. Machine A comes with a price tag of $15,000 and will
serve the company for a solid 10 years, saving them a cool $5,000 annually. On the
other hand, Machine B costs $12,000, has a lifespan of 5 years, and will also save the
company $5,000 each year.
Now, let's talk about the payback method. It's a nifty way to decide which machine to go
for, based on how quickly the company can recover the money they spent. In this
particular case, it's a no-brainer - Machine B is the way to go! Why, you ask? Well, it's
simple. Machine B will take less time for the savings from using it to equal the cost of
the machine. So, it's a win-win situation for the company!
By choosing Machine B, the company will not only save some serious cash but also
recover their investment in a shorter period of time. It's a smart move that will benefit the
company's bottom line. So, let's get that Machine B rolling and start grinding those
materials like there's no tomorrow!

Evaluation of the payback method

The payback method is a way for managers to figure out how long it'll take to make
enough money from an investment to pay back the initial amount of money that was
invested. However, it's not a good indicator of how profitable the investment will be
overall. Just because an investment has a shorter payback time doesn't mean it's a
better investment.
Let's take a look at two machines, A and B, for example. Machine B can pay back the
initial investment in less time than Machine A, but it has a useful life of only 5 years. On
the other hand, Machine A can offer the same service for the full 5 years without
needing to be replaced. So, even though Machine B has a shorter payback time,
Machine A is actually a better investment because it'll last longer.
The payback method also doesn't consider any money made after the initial investment
has been paid back. It also doesn't take into account the value of money over time. For
instance, getting $8,000 in 10 years is not the same as getting $8,000 right away. The
payback method treats these two scenarios as equal, but they're not.
Overall, the payback method can give managers an idea of how long it'll take to get their
money back from an investment, but it doesn't provide a complete picture of the
investment's profitability or consider the time value of money.

Extended Example of Payback

The payback period is the amount of time it takes to recover the money you initially
invested in something. For example, let's say you invest $10,000 in a machine for your
business. Each year, the machine brings in $2,000 in profit. To calculate the payback
period, you would divide the initial investment of $10,000 by the annual profit of $2,000,
which would give you a payback period of 5 years.

If you are replacing an old machine with a new one, you should subtract any money you
get from selling the old machine from the cost of the new machine. This way, you only
consider the extra money you are investing in the calculation. You should also include
any depreciation (decrease in value) you have already subtracted when calculating the
profit the project will bring in each year. This helps determine how much money you will
actually make from the project each year.
This example is about a company called Goodtime Fun Centers that is thinking about
replacing some of its vending machines with ice cream dispensing equipment in one of
its amusement parks. The ice cream equipment would cost $80,000 and last for eight
years without any resale value. They calculated that they would make $150,000 in sales
each year from the ice cream, with $90,000 in expenses, resulting in a net income of
$60,000. In addition, they have fixed expenses of $40,000, which includes salaries,
maintenance, and depreciation. After accounting for all these numbers, they determine
that they would have an annual net cash inflow of $30,000. To determine how long it
would take to recoup the investment in the ice cream equipment, they divide the initial
investment of $75,000 (after subtracting the anticipated resale value of the old
equipment) by the annual net cash inflow of $30,000, resulting in a payback period of
2.5 years.