The payback method helps fims establish and identify a maximum acceptable paybac

Question

The payback method helps fims establish and identify a maximum acceptable payback period that helps in their capital budgeting decisions. Consider the case of Fuzzy Button Clothing Company: Fuzzy Button Clothing Company 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, Fuzzy Button'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 -6,000,000 ,400,000 $6,000,000 Year 1 Year 2 Year 3 Expected cash flow Cumulative cash flow 5,100,000 $2,100,000 1,500,000 $3,600,000 Conventional payback period 1.70 years The conventional payback period ignores the time value of money, and this concerns Fuzzy Button's CFO. He has now asked you to compute Alpha's discounted payback period, assuming the company has a 7% 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 -6,000,000 $400,000 $5,100,000 $2,100,000 Cash flow Discounted cash flow Cumulative discounted cash flow Discounted payback period Which version of a project's payback period should the CFO use when evaluating Project Alpha, given its theoretical O 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 $3,957,217 O $2,411,755 O $1,714,226 O $6,168,764

Explanation / Answer

Cumulative Cash flow in year 0:-6000000
Cumulative Cash flow in year 1:-6000000+2400000=-3600000
Cumulative Cash flow in year 2:-3600000+5100000=1500000
Cumulative Cash flow in year 3:1500000+2100000=3600000
So, payback=1+3600000/5100000=1.705882

Discounted Cash flow in year 0:-6000000
Discounted Cash flow in year 1:2400000/1.07=2242991
Discounted Cash flow in year 2:5100000/1.07^2=4454538
Discounted Cash flow in year 3:2100000/1.07^3=1714226

Cumulative Discounted Cash flow in year 0:-6000000
Cumulative Discounted Cash flow in year 1:-6000000+2242991=-3757009
Cumulative Discounted Cash flow in year 2:-3757009+4454538=697529
Cumulative Discounted Cash flow in year 3:697529+1714226=2411755

Discounted pyaback=1+3757009/4454538=1.8434

Discounted payback is theoretically superior

Discounted pyaback fails to recognize 2411755

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