Blanda Incorporated management is considering investing in two alternative produ

Question

Blanda Incorporated management is considering investing in two alternative production systems. The systems are mutually exclusive, and the cost of the new equipment and the resulting cash flows are shown in the accompanying table. If the firm uses a 8 percent discount rate for their production systems. Year System 1 System 2 0 -$14,700 -$45,200 1 14,700 33,200 2 14,700 33,200 3 14,700 33,200 What are the payback periods for production systems 1 and 2? (Round answers to 2 decimal places, e.g. 15.25.) Payback period of System 1 is years and Payback period of System 2 is years

Explanation / Answer

Payback Period (PBP) is calculated by the process of cumulating the discounted cash flows till the time when the cumulated cash flows become equal to the original investment outlay. When such time period is a fraction more than complete years,

PBP = Complete Years + (Remaining Initial Investment not recovered upto complete years) / (Discounted cash flow of the fraction year)

Initial Cost of new equipment for System 1 = $14,700

Initial Cost of new equipment for System 2 = $45,200

Payback Period for System 1 = 1 + (1,088.89 / 12,602.88) = 1 + 0.09 = 1.09 years.

Payback Period for System 2 = 1 + (14,459.26 / 28,463.65) = 1 + 0.51 = 1.51 years.

Year Cash Flows ($)(System 1) Cash Flows ($)(System 2) Discounted Cash Flows ($) (System 1) Discounted Cash Flows ($) (System 2) 1 14,700 33,200 14,700 / 1.08 = 13,611.11 33,200 / 1.08 = 30,740.74 2 14,700 33,200 14,700 / (1.08)2 = 12,602.88 33,200 / (1.08)2 = 28,463.65 3 14,700 33,200 14,700 / (1.08)3 = 11,669.33 33,200 / (1.08)3 = 26,355.23

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