Payback and Internal Rate of Return?

Question

The management of Kitchen Shop is thinking of buying a new drill press to aid in adapting parts for different machines. The press is expected to save Kitchen Shop $8,000 per year in costs. However, Kitchen Shop has an old punch machine that isn't worth anythng on the market and that will probably last indefinitely. The new press will last 12 years and will cost $41,595. (Ignore inccome tax effects.)

1. Compute the payback period of the new machine

Answer 1

Simple linear calculation is 'how long does it take for the Savings (8k / yr) to pay for the equipment ?

This is 41595/8000 = 5.199 years (5 years 7 weeks, 2 days)

Needless to say, although mathematically correct it is total nonsense = no Business (that expected to survive) would base their decision on such a simplistic calculation...

Plainly Tax treatment (depreciation etc) can make a massive difference and the 'savings' quoted would need to be examined to see exactly how they have been arrived at = it is not unusual to discover that 'savings' include '10% of worker X' etc. which mean that the savings are not 'static' .. (unless no-one gets a pay increase for 5 years :-) ) .. and '100 square feet of factroy floor space'

The 'savings' might not even be realistically achievable = how do you make 10% of some-one Redundant ? .. or sell 100 sq. ft. of your factory ?

Finally, the COSTS associated with the new press do not seem to include any (one-off) Installation / Training or (annual) Operating, Maintenance or Insurance costs etc. = for sure you it will need to be installed (power & compressed air etc. feeds wil have to be run etc.) and it may well be necessary to recruit & train a new worker to operate the press ...

Answer 2

41595 / 8000 = 5.199 = 5yrs 73 days.