The payback method helps firms establish and identify a maximum acceptable payba

Question

The payback method helps firms establish and identify a maximum acceptable payback period that helps in their capital budgeting decisions. Consider the case of Cold Goose Metal Works Inc.: Cold Goose Metal Works Inc. is a small firm, and several of its managers are worried about how soon the firm will be able to recover its initial investment from Project Beta's expected future cash flows. To answer this question, Cold Goose's CFO has asked that you compute the project's payback period using the following expected net cash flows and assuming that the cash flows are received evenly throughout each year. Complete the following table and compute the project's conventional payback period. For full credit, complete the entire table. Year 0 Year 1 Year 2 Year 3 Expected cash flow Cumulative cash flow -6,000,000 $2,400,000 $5,100,000 $2,100,000 Conventional payback period: |

Explanation / Answer

Payback period = A + B/C

Where,
A = Last period with a negative cumulative cash flow;
B = Absolute value of cash flow at the end of the period A;
C = cash flow during the period after A.

Payback period = 1 + 3600000/5100000 = 1.71 years

Discounted payback period:

Discounted payback period = 1 + 37981655.14/4292567.97 = 1.88 years

- CFO should use discounted payback period, as it considers discounted values which are more relative.

- Discounted payback period fails to recognize the cash flows after the discounted payback period.

So option b - $1621585

Year Cashflow (A) Cumulative cash flow 0 -6000000.00 -6000000.00 1 2400000.00 -3600000.00 2 5100000.00 1500000.00 3 2100000.00 3600000.00

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