Q. Example on investment appraisal method ?
Contribution per unit = 3·00 - 1·65 = $1·35 per unit
Total annual contribution = 20000 × 1·35 = $27000 per year
Annual cash flow after fixed costs = 27000 - 10000 = $17000 per year
Payback period = 50000/17000 = 2·9 years
(Supposing that cash flows occur evenly throughout the year)
The payback period computed is greater than the maximum payback period used by Umunat plc of two years and on this basis should be rejected. Utilize of payback period as an investment appraisal method cannot be recommended but because payback period doesn't consider all the cash flows arising from an investment project as it ignores cash flows outside of the payback period. In addition payback period ignores the time value of money.
The reality that the payback period is 2·9 years must not therefore be a reason for rejecting the project. The project must be assessed using a discounted cash flow method such as net present value or internal rate of return since the project as a whole may generate an acceptable return on investment.