Question

Compute the payback period for each of these two separate investments: A new operating system for an existing machine is expected to cost $520,000 and have a useful life of six years. The system yields an incremental after-tax income of $150,000 each year after deducting its straight-line depreciation. The predicted salvage value of the system is $10,000.A machine costs $380,000, has a $20,000 salvage value, is expected to last eight years, and will generate an after-tax income of $60,000 per year after straight-line depreciation.

Answer 1

Answer:

The payback period for each of these two separate investments is 2.21 years and 3.62 years respectively.

Explanation:

Pay back period: The pay back period denotes that period in which the borrower is pay back the loan amount.

It shows a relationship between initial investment and annual cash inflows.

Mathematically,

Payback period = Initial Investment ÷ Annual cash inflows

where,

initial investment is the purchase amount

and, annual cash flows = incremental income + depreciation

1. For one investment, the depreciation amount is

= (Purchase amount - salvage value) ÷ useful life

= ($520,000 - $10,000) ÷ 6

= $85,000

So annual cash flows = $150,000 + $85,000

                                    = $235,000

Hence, the payback period = $520,000 ÷  $235,000

                                              = 2.21 years

2. For second investment, the depreciation amount is

= (Purchase amount - salvage value) ÷ useful life

= ($380,000 - $20,000) ÷ 8

= $45,000

So annual cash flows = $60,000 + $45,000

                                    = $105,000

Hence, the payback period = $380,000 ÷  $105,000

                                              = 3.62 years

Thus, the payback period for each of these two separate investments is 2.21 years and 3.62 years respectively.