Engineering Economic Analysis

282 OTHER ANALYSISTECHNIQUES

$3000 $3000

Cost=$3000

$2000 $2000

$1000 $1000

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o 1 2 3 4 5

Year Year

(a) (b)

FIGURE 9-3 Payback period plots for Example 9-7: (a) Atlas scale and (b) Tom Thumb scale.

Figure 9-3 illustrates the situation. To minimize payback period, select the Atlas scale.

There are four important points to be understood about payback period calculations:

1. This is an approximate, rather than an exact, economic analysis calculation.


2. All costs and all profits, or savings of the investment,prior to payback are included
   withoutconsidering differences in their timing..

3.All the economic consequences beyond the payback period are completely ignored.

4. Being an approximate calculation, payback period mayor may not select the cor-
   rect alternative. This is, the payback period calculations may select an alternative
   different from that found by exact economic analysis techniques..

This last point-that payback period may select thewrongalternative-was illustrated by

Example 9-7. When payback period is used, the Atlas scale appears to be the more attractive

alternative. Yet, when the same problem was solved earlier by the present worth method.

(Example 5-4), the Tom Thumb scale was the chosen alternative. A review of the problem

reveals the reason for the different conclusions.The $700 salvage value at the end of 6 years

for the TomThumb scale is a significantbenefit. The salvage value occurs after the payback

period, so it was ignored in the payback calculation. Itwasconsidered in the present worth

analysis, with the result that the Tom Thumb scale was in fact more desirable.

But if payback period calculations are approximate and may lead to the selection of the

wrong alternative, why is the method used at all? There are two primary answers: first, the

calculations can be readily made by people unfamiliar with economic analysis. One does

not need to know how to use gradient factors, or even to have a set of compound interest

tables. Second, payback period is a readily understood concept. Earlier we pointed out that

this was also an advantage to rate of return.

Moreover,payback perioddoesgive us a useful measure,telling us how long it will take

for the cost of the investmentto be recoveredfrom the benefitsof the investment.Businesses

and industrial firms are often very interested in this time period: a rapid return of invested

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