Do No Harm: 8/16 Attempts:8 7. The payback period The payback method helps firms

Question

Do No Harm: 8/16 Attempts:8 7. The payback period The payback method helps firms establish and identify a maximum acceptable payback period that helps in their Aa Aa capital budgeting decisions Consider the case of Blue Hamster Manufacturing Inc.: 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 Beta'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. Year O Year 1 Year 2 Year 3 Expected cash flow Cumulative cash flow 2,400,000 $ 5,100,000$2,100,000 6,000,000 Conventional payback period:

Explanation / Answer

CONVENTIONAL PAYBACK PERIOD: 0 1 2 3 Expected cash flow -6000000 2400000 5100000 2100000 Cumulative cash flow -6000000 -3600000 1500000 3600000 Conventional payback period = 1+3600000/5100000 = 1.71 years DISCOUNTED PAYBACK PERIOD: Cash flow -6000000 2400000 5100000 2100000 Discounted cash flow -6000000 2201835 4292568 1621585 Cumulative discounted cash flow -6000000 -3798165 494403 2115988 Discounted payback period = 1+3798165/4292568 = 1.88 years WHICH VERSION OF PAYBACK PERIOD - DISCOUNTED PAYBACK. VALUE NOT RECOGNIZED BY THE DISCOUNTED PAYBACK PERIOD = $2115988 (The value not recognized is equal to the NPV)

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