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. 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 Alpha'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. For full credit, complete the entire table. The conventional payback period ignores the time value of money, and this concerns Blue Hamster's CFO. He has now asked you to compute Alpha's discounted payback period, assuming the company has a 10% 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. For full credit, complete the entire table. Which version of a project's payback period should the CFO use when evaluating Project Alpha, given its theoretical superiority? 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?

Explanation / Answer

DISCOUNTED PAYBACK PERIOD

3818400/4212600=0.91

CFO SHOULD USE DISCOUNTED PAYBACK PERIOD VERSION WHEN EVALUATING PROJECT ALPHA

DISCOUNTED PAYBACK PERIOD METHOD FAILS TO RECOGNIZE APPROX $1971300 {(4212600-3818400)+1577100} NEAR ABOUT TO $1974455.

PARTICULARS YEAR 0 YEAR 1 YEAR 2 YEAR 3 EXPECTED CASH FLOW -6000000 $2400000 $5100000 2100000 CUMULATIVE CASH FLOW -6000000 $2400000 $7500000 9600000 1 36L/51L=0.71 CONVENTIONAL PAYBACK PERIOD 1.71 YEARS

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