and would require a $450,000 investment in equipment which has no salvage value.
ID: 2383896 • Letter: A
Question
and would require a $450,000 investment in equipment which has no salvage value. The project would provide net operating income each year as follows for the life of the project:
Sales ............................................... . $500,000
Less cash variable expenses ............ . 200,000
Contribution margin ........................ . 300,000
Less fIxed expenses:
fixedcash expenses ..................... .$150,000
Depreciation expenses .................. .45,000 . 195.000
Net operating income ...................... $105,000
The company's required rate of return is 12%.
What is the payback period for this project?
Explanation / Answer
According to the given information,
Net operating income (EBIT) = $105,000
Depreciation = $45,000
Required rate of return = 12%
First, we have to calculate the operating cash flows for the first 10 yrs, and then we have to calculate the Payback period.
Operating cash flows = EBIT + Depreciation - Taxes
In this problem, income taxes are ignored. Hence the effect of tax on cash flows is zero.
Substituting the values in the above formula, we get
Operating cash flows = $105,000 + $45,000 - $0
= $150,000
Therefore, the operating cash flows for 10yrs is $150,000
The cash flows are even (same) for 10yrs. The formula for calculating the payback period is
Payback period = Cost of the investment / Net annual cash flows
= $450,000 / $150,000
= 3yrs
Therefore, the time to recover the initial investment is 3yrs.
Hence the payback period is 3yrs
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