The conventional payback period ignores the time value of money, and this concer

Question

The conventional payback period ignores the time value of money, and this concerns Fuzzy Button'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 One theoretical disadvantage of both payback methods-compared to the net present value method-is that they fail to consider the value of the cash flows beyond the point in time equal to the payback period. How much value does the discounted payback period method fail to recognize due to this theoretical deficiency? $6,039,476 $3,889,270 $1,667,048 $2,261,698

Explanation / Answer

The table is as shown below:

Discounted Payback period = Last year with negative cumulative cash flow + Absolute value of the cumulative cash flow / Cash flow next year = 1 + 3777777.78/4372427.98 = 1 + 0.864 = 1.86 years

The CFO should use : Discounted Payback Period

It fails to recogize ther cash flow after the discounted payback period

It fails to recogize the remaining cash flow in year 2 (594650.21) and the full cash flow in year 3(1667047.71). So in total it fails to recognize = 594650.21 +1667047.71 = 2,261,697.92 =2,261,698

Hence answer is option 4 : $2,261,698

Year 0 1 2 3 Cash flow -6000000 2400000 5100000 2100000 Dsciounted Cash flow -6000000 2222222.22 4372427.98 1667047.71 Cumulative cash flow -6000000 -3777777.78 594650.21 2261697.91

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