9: Capital Budgeting Process and Decision Criteriachange their production processes to reduce the quantity of this harmful chemical, and the demand for
testing will eventually decline.
Ana-Lab does not currently have the technology to run the necessary tests, so it will have to
buy several new machines called gas chromatographs. Two different types of gas chromatograph are
available, both of which have a useful operating life of about six years. One type, Type A, is less
expensive and cheaper to operate than the other. The other type, Type B, costs a great deal more, but
in principle it can be used to perform many additional kinds of chemical tests. Ana-Lab’s CEO, Mr
Whitehead, believes that over time he could find new customers who would pay for the additional
types of tests that the Type B chromatographs can perform. At the end of its life, the Type B machine
must be removed from Ana-Lab’s facility at great cost, a cost large enough that in the final year
of operating the Type B machines, the net cash flow
is negative. The estimated cash flows associated with
each type of machine appear below:
Mr Whitehead asks you to provide analysis to help
him determine which chromatograph to purchase. He
is particularly interested in knowing how quickly each
machine will pay back its initial cost and the rate of
return that each machine offers. He tells you that, if
he does not spend money on new gas chromatographs,
he will probably replace some existing equipment in
the lab, and he would expect to earn a return of about10% on that type of investment. As you sit down to begin your analysis, a number of questions
come to mind.
■ What is the payback period of each machine?
■ What are the pros and cons of focusing on payback as a decision criterion in this particular case?
■ What is the internal rate of return provided by each machine?
■ What problems could arise if Mr Whitehead chooses the machine with the highest IRR?
■ What hurdle rate ought to be applied to an investment like this?
9 -7a PAYBACK PERIOD
The Type A machine produces cash flow of $800,000 in its first two years and $250,000 in its third
year. Therefore, it pays back the initial $1,000,000 cost about four-fifths of the way through year 3
($200,000 ÷ $250,000 = 0.8). Its payback period is 2.8 years. The Type B machine generates cash flow
of $2,050,000 during its first three years and $1,500,000 in its fourth year. Therefore, it earns back the
initial $3,200,000 cost in 3.77 years ($1,150,000 ÷ $1,500,000 = 0.77). Based on payback analysis, the
Type A chromatograph seems more attractive.
You recall that the payback approach fails to account for the time value of money and completely
ignores cash flows beyond the payback period. The Type A machine produces most of its cash flows
early in its life, while the Type B machine generates larger cash flows in the later years (but it also has a
significant negative cash flow in year 6). Because the timing of the cash flows generated by each machine
Year Type A chromatograph Type B
chromatograph
0 –$1,000,000 –$3,200,000
1 450,000 500,000
2 350,000 550,000
3 250,000 1,000,000
4 200,000 1,500,000
5 150,000 2,000,000
6 125,000 –600,000