Question

6. The payback period The payback method helps firms establish and identify a maximum acceptable payback period that helps in their capital budgeting decisions. Consider the case of Green Caterpillar Garden Supplies Inc.: Green Caterpillar Garden Supplies 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 Alpha's expected future cash flows. To answer this question, Green Caterpillar'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. (Note: Round the conventional payback period to two decimal places. If your answer is negative, be sure to use a minus sign in your answer.) Year O Year 1 Year 2

Answer 1

1 B Year o (4,500,000) (4,500,000) C Year 1 1,800,000 (2,700,000) D Year 2 3,825,000 1,125,000 Year 3 1,575,000 2,700,000 2 Expected cash flow 3 Cumulative cash flow 4 5 Conventional payback period 1.7059 years Year 0 Year 1 Year 2 Year 3 9 Expected cash flow (4,500,000) 1,800,000 3,825,000 1,575,000 10 Discounted Cash flow (4,500,000) 1,651,376 3,219,426 1,216,189 11 Cumulative cash flow (4,500,000) (2,848,624) 370,802 1,586,991 12 13 Conventional payback period 1.8848 years 14 15 Given discounted payback takes time value of money into consideration, that is a superior approach 16 to regular payback 17 18 19 Discounted payback fails to recognize value 1,586,991 20

B Year o Ε Year 3 1 Year 1 Year 2 1800000 2 Expected cash flow 3 Cumulative cash flow -4500000 =B2 3825000 =C3+D2 1575000 =D3+E2 =B3+C2 =1+(-C3/D2) years 5 Conventional payback period 6 7 8 9 Expected cash flow 10 Discounted Cash flow 11 Cumulative cash flow Year o Year 2 =D2 =B2 =B9/(1+9%)^0 =B10 Year 1 =C2 =C9/(1+9%)^1 =B11+C10 Year 3 =E2 =E9/(1+9%)^3 =D11+E10 =D9/(1+9%)^2 =C11+D10 12 13 Conventional payback period =1+-C11/D10) 1/010) years 14 15 16 Given discounted payback takes time value of money into consideration, that is a superior approach to regular payback 18 19 Discounted payback fails to recognize value =E11