PART 3: CAPITAL BUDGETINGdepicts the projected cash inflows and outflows
of each project over the next five years. By
investing $250 million, Global Untethered
could add up to 100 new mobile sites to its
existing base in Western Europe, giving it the
most comprehensive service area in that region.
Company analysts project that this investment
could generate year-end net after-tax cash inflows that could grow over the next five years, as outlined
below:
Alternatively, Global Untethered could make a much smaller investment to establish a toehold in
a new market in South-eastern Australia. For an initial investment of $50 million, Global Untethered
believes it can create a south-eastern network, with its hub centred in Sydney. The projected end-of-year
cash flows associated with this project are as follows:
Which investment should Global Untethered make? If the company can undertake both investments,
should it do so? If it can make only one investment, which one is better for shareholders? We will see
how different capital budgeting techniques lead to different investment choices, starting with the
payback method.9-2 PAYBACK METHODS
In this section we evaluate the use of the payback period and the discounted payback methods
by assessing their pros and cons. Both methods are typically used to assess the impact of capital
expenditures.9-2a THE PAYBACK DECISION RULE
The payback method is the simplest of all capital budgeting decision-making tools; it enjoys widespread
use, particularly in small companies. The payback period is the time it takes for a project’s cumulative
net cash inflows to recoup the initial investment. Companies using the payback approach define a
maximum acceptable payback period and accept only those projects that have payback periods less
than the maximum; all other projects are rejected. If a company decides that it wants to avoid any
investment that does not ‘pay for itself ’ within three years, then the payback decision rule is to accept
projects with a payback period of three years or less and reject all other investments. If several projects
satisfy this condition, then companies may prioritise investments based on which ones achieve payback
more rapidly. The decision to use three years as the cut-off point is somewhat arbitrary, and there are
no hard-and-fast guidelines that establish what the ‘optimal’ payback period should be. Nevertheless,
suppose that Global Untethered uses three years as its cut-off when applying payback analysis. What
investment decision would it make?1 What characteristics does management desire in a capital budgeting technique?CONCEPT REVIEW QUESTIONS 9-1
LO9.2payback period
The amount of time it takes for
a project’s cumulative net cash
inflows to recoup the initial
investment
Initial outlay –$50 million
Year 1 inflow $18 million
Year 2 inflow $22 million
Year 3 inflow $25 million
Year 4 inflow $30 million
Year 5 inflow $32 million