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 the case of Green Caterpillar Garden Supplies Inc. Green Caterpillar Garden Supplies 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, Green Caterpillar'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 -4,500,000 $1,800,000 $3,825,000 $1,575,000 Conventional payback period The conventional payback period ignores the time value of money, and this concerns Green Caterpillar's CFO. He has now asked you to compute Alpha's discounted payback period, assuming the company has a 9% 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 Year 0 Year 1 Year 2 Year 3 Cash flovw Discounted cash flow Cumulative discounted cash flow -4,500,000 $1,800,000 $3,825,000 $1,575,000 Discounted payback period Which version of a project's payback period should the CFO use when evaluating Project Alpha, 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 does the discounted payback period method fail to recognize due to this theoretical deficiency? O $1,216,189 O $1,586,991 $2,867,565 $4,435,615

Explanation / Answer

Cumulative Cash Flow is the sum of all previous cash flows.

Payback Period (PBP) is the no. of years it takes to recover investment. We see that in year 2 the cumulative cash flow turns positive, which means.

PBP = 1 + 2,700,000 / 3,825,000 = 1.71

Discounted Cash Flows (DCF) is the present value of future cash flows

DCF = CFn / (1 + r)^n

For year 1, DCF = 1,800,000 / (1 + 9%)^1 = 1,651,376

For year 2, DCF = 3,825,000 / (1 + 9%)^2 = 3,219,426

For year 3, DCF = 1,575,000 / (1 + 9%)^3 = 1,216,189

Cumulative DCF is the sum of previous DCFs.

and Discounted Payback Period (DPBP) is calculated using cumulative discounted cash flows

DPBP = 1 + 2,848,624 / 3,219,426 = 1.88

The CFO should use discounted payback period as it accounts for cost of capital.

We can see that DPBP doesn't consider the value beyond the initial investment, which is equal to $1,586,991

0 1 2 3 CF -4,500,000 1,800,000 3,825,000 1,575,000 Cum. CF -4,500,000 -2,700,000 1,125,000 2,700,000 PBP 1.71 DCF -4,500,000 1,651,376 3,219,426 1,216,189 Cum. DCF -4,500,000 -2,848,624 370,802 1,586,991 DPBP 1.88

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