The payback method helps firms establish and identify a maximum acceptable payback period that helps in capital
Question:
The payback method helps firms establish and identify a maximum acceptable payback period that helps in capital budgeting decisions. There are two versions of the payback method: the conventional payback method and the discounted payback method.
Consider the following case:
Cold Goose Metal Works 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 Beta’s expected future cash flows. To answer this question, Cold Goose’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. Round the payback period to the nearest two decimal places. Be sure to complete the entire table—even if the values exceed the point at which the cost of the project is recovered.
| Year 0 | Year 1 | Year 2 | Year 3 | |
|---|---|---|---|---|
| Expected cash flow | $-4,000,000 | $1,600,000 | $3,400,000 | $1,400,000 |
| Cumulative cash flow | ||||
| Conventional payback period: | years |
The conventional payback period ignores the time value of money, and this concerns Cold Goose’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. Again, be sure to complete the entire table—even if the values exceed the point at which the cost of the project is recovered.
| Year 0 | Year 1 | Year 2 | Year 3 | |
|---|---|---|---|---|
| Cash flow | $-4,000,000 | $1,600,000 | $3,400,000 | $1,400,000 |
| Discounted cash flow | ||||
| Cumulative discounted cash flow | ||||
| Discounted payback period: | years |
Which version of a project’s payback period should the CFO use when evaluating Project Beta, given its theoretical superiority?
The discounted payback period
The regular payback period
Expert Answer:
Solution Construct the table to calculate Conventional payback period using excel as follows ... View the full answer
