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 7% 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 0 Year 1 Year 2 Year 3 $5,100,000 $2,100,000 Cash flow Discounted cash flow Cumulative discounted cash flow -6,000,000 ,400,000 Discounted payback period Which version of a project's payback period should the CFO use when evaluating Project Alpha, given its theoretical O The discounted payback period O 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? O $3,957,217 O $2,411,755 O $1,714,226 O $6,168,764

Explanation / Answer

Discounted payback period is theoretically more superior. Hence this should be used by CFO when evaluating Project Alpha

Discounted cash flows

Year 0: -6000000

Year 1: 2400000/1.07=2242991

Year 2: 5100000/1.07^2=4454538

Year 3: 2100000/1.07^3=1714226

Cumulative discounted cash flows

Year 0: -6000000

Year 1: -6000000+2242991=-3757009

Year 2: -3757009+4454538=697529

As we see the last year where cumualtive discounted cash flows is negative is year 1

hence, discounted payback=1+3757009/4454538=1.843

As the period is close to 2 years, so we will consider cash flows till year 2 but ignore year 3 cash flows, which is 1714226.The discpounted pyaback period method fails to recognize 1714226 due to its theoretical deficiency

So, option C

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