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MARY JO,

Capital budgeting is often considered by managers. Since this involves large cash expenditures, it is imperative that managers evaluate the investment’s lifetime cash inflows and outflows as well its profitability. Two methods commonly used to evaluate capital budgeting projects include the payback method and the simple rate of return method .

The payback method measures the payback period or the “length of time that it takes for a project to recover its initial cost from the net cash inflows that it generates” (Garrison, Noreen & Brewer, 2015). To compute the formula for the payback period, we divide the investment required by the annual net cash inflow. The textbook explained this by comparing two milling machines that the York Company is considering to purchase. The costs of machines’ A and B are $15,000 and $12,000, and their useful lives are 10 and 5 years, respectively. Both machines have an annual net cash inflow of $5,000. In calculating the payback period for both machines, Machine B yields shorter payback period of 2.4 years ($12,000/$5,000), while Machine A, 3.0 years ($15,000/$5,000). Based on this calculation, Machine B seems more reasonable to purchase because of the shorter payback period. As the Dictionary of Marketing (2011) describes it, “normally, a good investment is one with the shortest payback period” (p. 130). However, take note of the word “normally” that the dictionary used to describe a good investment. This implies that a shorter payback period isn't always desirable. For instance, in the above example, Machine B has a useful life of only 5 years. After the 5 years are up, the machine would be useless and the company will need to purchase a new one, unlike Machine A that has a useful life of 10 years. So in essence, it is far more practical to purchase Machine A that will last another 5 more years. Moreover, the payback period does not take into account the time value of money, a concept which “values how much more a given sum of money is worth now (or at a specific future date) compared to in the future (or, in the case of a future payment, a date that is even further in the future)” (“Time Value of Money,” 2014). In other words, it does not make a distinction of the value of money or investment in different times or periods.

The simple rate of return method on the other hand is “often referred to as the accounting rate of return or the unadjusted rate of return” (Garrison et al, 2015). To compute the simple rate of return, we divide the annual incremental net operating income (less any depreciation charges from new investment) by the initial investment (less any salvage value obtained from selling old equipment) (Garrison et al, 2015). The major drawback of this method is that it is relative to the amount of accounting net operating income which then requires incremental revenues and expenses to be constant over the investment’s useful life, if not, the simple rates of return will vary in some years (Garrison et al, 2015). In addition, similar to the payback method, it ignores the time value of money.

 References

Doyle, C. (2011). A dictionary of marketing (3 ed.). New York: Oxford University Press.

Garrison, R.H., Noreen, E.W., & Brewer, P.C. (2015). Managerial accounting (15th ed.). New York, NY: McGraw-Hill/Irwin