The Payback Period Green Caterpillar Garden Supplies Inc. is a small firm, and s

Question

The Payback Period

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 Beta'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 O Year 1 Year 2 Year 3 Expected cash flow Cumulative cash flow -5,500,000 $2,200,000 $4,675,000 $1,925,000 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 Beta'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 Year O Year 1 Year 2 Year 3 Cash floww Discounted cash flow Cumulative discounted cash flow -5,500,000 $2,200,000 $4,675,000 $1,925,000 Discounted payback period Which version of a project's payback period should the CFO use when evaluating Project Beta, given its theoretical superiority? The regular payback period O The discounted payback period

Explanation / Answer

Answer:

1

Conventional payback period

Year-0

Year-1

Year-2

Year-3

Expected cash flow

($5,500,000)

$2,200,000

$4,675,000

$1,925,000

Cumulative cash flow

($5,500,000)

($3,300,000)

$1,375,000

$3,300,000

Conventional payback
period

1.71 years

Conventional payback period

= 1 year + {$3,300,000/$4,675,000}

= 1 year + 0.71 years

= 1.71 years

__________________________________________

2

Discounted payback period

Year-0

Year-1

Year-2

Year-3

Expected cash flow

($5,500,000)

$2,200,000

$4,675,000

$1,925,000

Discounting factor at 10%

1

0.9091

0.8264

0.7513

Discounted cash flow

($5,500,000)

$2,000,000

$3,863,636

$1,446,281

Cumulative cash flow

($5,500,000)

($3,500,000)

$363,636

$1,809,917

Conventional payback
period

1.91 years

Discounted payback period

= 1 year + {$3,500,000/3,863,636}

= 1 year + 0.91 years

= 1.91 years

___________________________________________________________

3

.Which version of a project's payback period should the CFO use when evaluating Project Alpha, given its theoretical superiority?

Answer:

The discounted payback

____________________________________________________

4

Answer: =1,809,917

Year-0

Year-1

Year-2

Year-3

Expected cash flow

($5,500,000)

$2,200,000

$4,675,000

$1,925,000

Cumulative cash flow

($5,500,000)

($3,300,000)

$1,375,000

$3,300,000

Conventional payback
period

1.71 years

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