6. The payback period Aa Aa The payback method helps firms establish and identif

Question

6. 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 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 Omega'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 0 Year 1 Year 2 Year 3 4,500,000 Expected cash flow Cumulative cash flow $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 Blue Hamster's CFO. He has now asked you to compute Omega'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.

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.

a.

Payback period = 1 + 2700000/3825000 = 1.71 years

b.

Discounted payback

DPB = 1 + 2863636.36/3161157.02 = 1.91 years

C.

CFO would use Discounted payback period method.

D.

Option D - 1480841

Becasue DPB method ignores the cashflows after the final year

2.

a. All the three statements are true.

b. NPV method is the single best method to use when making capital budgeting decisions.

Year Cashflow (A) Cumulative 0 -4500000.00 -4500000.00 1 1800000.00 -2700000.00 2 3825000.00 1125000.00 3 1575000.00 2700000.00

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