6. The payback period Aa Aa The payback method helps firms establish and identif

Question

6. The payback period Aa Aa The payback method helps firms establish and identify a maximum acceptable payback period that helps in their capital budgeting decisions Consider this case: Cute Camel Woodcraft Company 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, Cute Camel'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 5,000,000 $2,000,000 $4,250,000 1,750,000 Conventional payback period: The conventional payback period ignores the time value of money, and this concerns Cute Camel's CFO. He has now asked you to compute Beta's discounted payback period, assuming the company has a 9% 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.

Explanation / Answer

Conventional Pay Back Method = Initial Invetment/Annual Pay Back Amount

here initial amount =$ 5000,000

and 1 st year annul pay back amount is =$2000,000

2 year annual pay back amount is = $ 4250000

so the pay back period = 5000,000/2000,000+(4250,000)

means the 1 year anuula pay back amount of $ 2000,000 covers the initial amount of $ 5000,000

and the remaing initial amount is coverd by the 2 years pay back amount

i.e remaining $ 3000,000 is to be coverd from the 2 years earnings

so the pay back period =1 year 8 .47 months (4250,000 earns in 12 months 3000,000 how many months)

Discounted Method=discounted cash flows at 9% intrest rate for 3 years

1 year discounted cash flow =1834,000

2 year =3578,000

so as done in conventional metod , year 1 discounted cahs flow of 1834000 covers the initial amount of 5000,000 and the remaining amount covers from the 2 years discounted cash flow of 3578,000

( to earn 3578,000 it takes 12 months to earn 3166000 how many months it takes 10.61 months)

so the pay back period as per discounted cash flow =1year 10.61 months

The Discounted Pay Back period method is superior

An amount of $ 1351,000 of discounted amount is left unrecognised due to theoretical deficiency

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