Question

Henry Co. is considering acquiring a manufacturing plant. The purchase price is \(1,200,000. The owners believe the plant will generate net cash inflows of \)325,000 annually. It will have to be replaced in six years. Use the payback method to determine whether Henry should purchase this plant. Round to one decimal place.

Short answer

Henry should purchase the plant as the payback period is 3.7 years.

Step-by-step solution

Meaning of Payback period

A capital budgeting technique shows the years required to recover the initial investment cost, known as the payback period.

Determining whether Henry should purchase the plant

Calculating payback period

$\begin{array}{rcl}Paybackperiod& =& \frac{Initialinvestment}{Annualnetcashflows}\\ & =& \frac{1,200,000}{325,000}\\ & =& 3.7years\end{array}$

Henry should adopt this plant since the payback period is shorter than the time it will take to replace it.