10. The payback period Aa Aa The payback method helps firms establish and identi
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Question
10. The payback period Aa Aa The payback method helps firms establish and identify a maximum acceptable payback period that helps in their capital budgeting decisions Consider the case of Cold Goose Metal Works Inc.: Cold Goose Metal Works 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, Cold Goose'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. Year 0 Year 1 Year 2 Year 3 Expected cash flow Cumulative cash flow 5,500,000 $2,200,000 $4,675,000 $1,925,000 Conventional payback period:Explanation / Answer
Payback period = A + B/C
Where,
A = Last period with a negative cumulative cash flow;
B = Absolute value of cash flow at the end of the period A;
C = cash flow during the period after A.
Payback period = 1 + 3300000/4675000 = 1.71 years
Discounted payback period = 1 + 3443925.23/4083326.05 = 1.84 years
- CFO should use the discounted payback period, because it takes the expeced cashflows' time value of money into account.
- Option C. Discounted payback period assumes that a project ceases to generate cashflow at a point in time equal to the discounted payback period. But the project actually generates another $2210774 in shareholder wealth (The last discounted value)
Year Cashflow (A) Cummulative 0 -5500000.00 -5500000.00 1 2200000.00 -3300000.00 2 4675000.00 1375000.00 3 1925000.00 3300000.00Related Questions
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