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 this case: Fuzzy Button Clothing Company 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, Fuzzy Button'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 Fuzzy Button's CFO. He has now asked you to compute Omega's discounted payback period, assuming the company has a 7% 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 Omega, given its theoretical superiority The discounted payback period The regular payback periodOne 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 $5,140,636 $3,297,680 $1,428,521 $2,009,795

Explanation / Answer

Now In 2nd year,in 12 months 4250000 cash flow is generated but we need time required to generate 3000000.

Thus T=3000000*12/4250000

T=8.47 Months

Thus total payback period is 1 year and 8.47 months.

Now After 1st year, $3130841 are yet to be recovered. In 2nd year $3712115 are earned in 12 months

Thus, T=3130841*12/3712115

T= 10.12

Discounted payback period = 1 year and 10.12 months

In real life time value of money holds true so cost of capital should be taken into account

Discounted payback period is more relevant.

The discounted payback method fail to recognize $2009795 due to theoretical in efficiency.

year 0 year 1 year 2 year 3 Cash Flow -5000000 2000000 4250000 1750000 Cumulative cash flow -5000000 -3000000 1250000 3000000

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