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: 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 Delta'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 Delta'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 Delta, given its theoretical superiority? The discounted payback period O The regular 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 deeps the discounted payback period method fail to recognize due to this theoretical deficiency? 52,819,685 S4,344,478

Explanation / Answer

Ans. (1) : 1.7 year Conventional payback method Year 0 Year 1 Year 2 Year 3 Expected cash fow (in $) -4500000 1800000 3825000 1575000 Cumulative cash flow (in $) -4500000 -2700000 1125000 2700000 Conventional payback period : 1.71 year working ::: outflow -4500000 Inflow year 1 1800000 Inflow year 2 2700000 balance amount required for payback 0.705882 ~ 1+0.7 = 1.7 year 2700000/3825000 Discounted payback method Ans. (1) : 1.91 year Year 0 Year 1 Year 2 Year 3 Expected cash fow (in $) -4500000 1800000 3825000 1575000 Discounted cash flow (in $) -4500000 1636364 3161157 1183321 Cumulative disc.cash flow (in $) -4500000 -2863636 297521 1480842 Discounted payback period : 1.91 year Working : discounted cash flow @ 10% Year Cash flow DF DCF 1 1800000 0.909091 1636364 2 3825000 0.826446 3161157 3 1575000 0.751315 1183321 as per above , as discounted payback period method consider time value of money, this method is supriority

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