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Chapter 11 Home Grades Personalized Reviews Discussion Course Materials he Basics of Capital Budgeting aded Assignment |Read Chapter 11 | Back to Assignment Due Sunday 07.01.18 at 11:45 P Attempts: Keep the Highest: /16 6. The payback period Aa Aa ? payback method helps firms establish and identify a maximum acceptable payback period that helps in their capital budgeting decisions Consider the case of Green Caterpillar Garden Supplies Inc. 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 Omega'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 1 Year 0 5,000,000 Year 2 Year 3 $1,750,000 Expected cash fiow Cumulative cash flow $2,000,000 Conventional payback period: The conventional payback period ignores the time value of money, and this concerns Green Caterpitlar'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 Year o Year 1 Year 2 Year 3 Cash flow 5,000,000 $2,000,000 $4,250,000 $1,750,000 MacBook Ai

Explanation / Answer

6. The payback period:

Conventional Payback period does not take time value of money into consideration. It simply calculates the time period within which the initial investment can be recovered. Here the initial investment is 5,000,000 which is recovered somewhere between Year 1 and Year 2. To find out when exactly was it recovered, we use interpolation.

Using interpolation, Payback period = 1 year + [(5,000,000-2,000,000)/4,250,000] = 1.7059 years i.e approx 1.706 years.

Now, we find discounted payback period i.e. the payback period which considers time value of money and discounts the cash flow with the appropriate discounting rate. The discounting rate here is 10% (given) so we discount Year 1,2 & 3 cash flows with 10%

Discounted inflow in Year 1 = 2,000,000/1.10 = 1,818,182

Discounted inflow in Year 2 = 4,250,000/ (1.10^2) = 3,512,397

Discounted inflow in Year 3 = 1,750,000/(1.10^3) = 1,314,801

HERE AGAIN TO FIND DISCOUNTED PAYBACK PERIOD, WE USE INTERPOLATION

using interpolation, discounted payback period = 1 year + [(5000000-1818182)/3512397] = 1.906 years

The cash flows have been received over the period of 4 years and therefore time value has an important role to plau. Therefore we should go for Discounted Payback period for Omega as it gives due importance to the timings of the cash flows.

If we solve the same question using NPV method (where the discounted cash flows calculated above will have a role to play), the NPV = Present value of inflow - Present value of Outflow

Therefore, NPV = (1818182 + 3512397 + 1314801) - 5000000

Therefore NPV = 1,645,379 (approx = $ 1,645,380)

This means that discounted payback value method considers amount only upto its initial outflow, beyond that it does not consider. The amount it does not consider is $ 1,645,380 i.e. first option among the given choices.

PARTICULARS    YEAR 0 YEAR 1 YEAR 2 YEAR 3 EXPECTED CASH FLOW -5,000,000 2,000,000 4,250,000 1,750,000 CUMULATIVE CASH FLOW -5,000,000 -3,000,000 1,250,000 3,000,000 CONVENTIONAL PAYBACK PERIOD 1.7059 YEARS

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