The payback method helps firms establish and identify a maximum acceptable payba
ID: 2651714 • Letter: T
Question
The payback method helps firms establish and identify a maximum acceptable payback period that helps in their capital budgeting decisions, Consider this case: Blue Hamster Manufacturing 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 Omega's expected future cash flows. To answer this question, Blue Hamster'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. The conventional payback period ignores the time value of money, and this concerns Blue Hamster's CFO. He has now asked you to compute Omega's discounted payback period, assuming the company has a 9% cost of capital. Complete the following table and perform any necessary calculations. Round the discounted cash flow values to the nearest whole dollar, and the discounted payback period to the nearest two decimal places. Which version of a project's payback period should the CFO use when evaluating Project Omega, given its theoretical superiority? The regular payback period The discounted payback period One theoretical disadvantage of both payback methods-compared to the net present value method-is that they fail to consider the value of the cash flows beyond the point in time equal to the payback period. How much value does the discounted payback period method fail to recognize due to this theoretical deficiency? $4,435,615 $1,586,991 $2,867,565 $1,216,189Explanation / Answer
Answer:
Calculation of Conventional Payback period:
Year 0
Year 1
Year 2
Year 3
Expected cash flows
$ (4,500,000)
$ 1,800,000
$ 3,825,000
$ 1,575,000
Cumulative Cash flows
$ (4,500,000)
$ (2,700,000)
$ 1,125,000
$ 2,700,000
We can see that cumulative cash flows become positive in year 2 , hence Payback period is =
1 year + (2700000 / 3825000)
=
1.71
Years
Calculation of Conventional Payback period:
Year 0
Year 1
Year 2
Year 3
Expected cash flows
$ (4,500,000)
$ 1,800,000
$ 3,825,000
$ 1,575,000
PVF (9%)
1.00000
0.91743
0.84168
0.77218
Discounted Cash flows
$ (4,500,000)
$ 1,651,376
$ 3,219,426
$ 1,216,189
Cumulative Discounted Cash flows
$ (4,500,000)
$ (2,848,624)
$ 370,802
$ 1,586,991
We can see that cumulative Discounted cash flows become positive in year 2 , hence Payback period is =
1 year + (2848624 / 3219426)
=
1.88
Years
Discounted Payback Period gives the better evaluation basis as it considers present value.
Calculation of Conventional Payback period:
Year 0
Year 1
Year 2
Year 3
Expected cash flows
$ (4,500,000)
$ 1,800,000
$ 3,825,000
$ 1,575,000
Cumulative Cash flows
$ (4,500,000)
$ (2,700,000)
$ 1,125,000
$ 2,700,000
We can see that cumulative cash flows become positive in year 2 , hence Payback period is =
1 year + (2700000 / 3825000)
=
1.71
Years
Calculation of Conventional Payback period:
Year 0
Year 1
Year 2
Year 3
Expected cash flows
$ (4,500,000)
$ 1,800,000
$ 3,825,000
$ 1,575,000
PVF (9%)
1.00000
0.91743
0.84168
0.77218
Discounted Cash flows
$ (4,500,000)
$ 1,651,376
$ 3,219,426
$ 1,216,189
Cumulative Discounted Cash flows
$ (4,500,000)
$ (2,848,624)
$ 370,802
$ 1,586,991
We can see that cumulative Discounted cash flows become positive in year 2 , hence Payback period is =
1 year + (2848624 / 3219426)
=
1.88
Years
Discounted Payback Period gives the better evaluation basis as it considers present value.
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