A convenience store owner is contemplating putting a large neon sign over his st

Question

A convenience store owner is contemplating putting a large neon sign over his store. It would cost $50,000, but is expected to bring an additional $24,000 of profit to the store every year for five years. Would this project be worthwhile if evaluated using a payback period of two years or less and if the cost of capital is 10%?

A.    Yes, since it will pay back its initial investment in two years.

B.    No, since the value of the cash flows over the first two years are less than the initial investment.?

C.    Yes, since the value of the cash flows into the store, in present dollars, are greater than the initial investment.

D.    Yes, since the cash flows after two years are greater than the initial investment.

A convenience store owner is contemplating putting a large neon sign over his store. It would cost $50,000, but is expected to bring an additional $24,000 of profit to the store every year for five years. Would this project be worthwhile if evaluated using a payback period of two years or less and if the cost of capital is 10%?

Explanation / Answer

Calculation of payback period:

At Year 3 Cumulative Cash Flow is $22000

At Year 2 Cumulative Cash Flow is -$2000

This implies For 1 year there is an increase of cash flow of $24000 (22000 + 2000), for how much time,, cash flow increases by 2000?

Answer is 0.0833 year (2000 / 24000)

Therefore payback period = 2 + 0.0833 = 2.0833 year

Here it is given that the payback period is 2 years or less.

Correct Option is

B) No, since the value of the cash flows over the first two years are less than the initial investment

Year Cash Flow Cumulative Cash Flow 0 -50000 -50000 1 24000 -26000 2 24000 -2000 3 24000 22000 4 24000 46000 5 24000 70000

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