Blue Hamster Manufacturing Inc. is a small firm, and several of its managers are

Question

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 Alpha'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. The conventional payback period ignores the time value of money, and this concerns Blue Hamster's CFO. He has now asked you to compute Alpha's discounted payback period, assuming the company has a 8% 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. Which version of a project's payback period should the CFO use when evaluating Project Alpha, given its theoretical superiority? The discounted payback period The regular payback period

Explanation / Answer

Solution:

Calculation of 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 Flows

$2,200,000

$6,875,000

$8,800,000

Conventional Payback period

1.294 Years

Conventional Payback Period = 1 year + ($6,875,000 - $5,500,000) / $4,675,000 = 1 year + 0.294 year = 1.294 years

Calculation of 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 @ 8%

1.000

0.926

0.857

0.794

Discounted Cash Flow

($5,500,000)

$2,037,037

$4,008,059

$1,528,127

Cumulative Cash Flows

$2,037,037

$6,045,096

$7,573,223

Conventional Payback period

1.136 Years

Discounted Payback Period = 1 year + ($6,045,096 - $5,500,000) / $4,008,059

= 1 year + 0.136 year

= 1.136 years

The CFO should use discounted payback period of a project when evaluating project ALPHA.

Discounted payback period considers time value of money which is very important for a project.

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 Flows

$2,200,000

$6,875,000

$8,800,000

Conventional Payback period

1.294 Years

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