Question

4. 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 Blue Hamster Manufacturing Inc.: Blue Hamster Manufacturing 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 Delta's expected future cash flows. To answer this question, Blue Hamster'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 1 Year 0 -$6,000,000 Year 2 $5,100,000 Year 3 $2,100,000 $2,400,000 Expected cash flow Cumulative cash flow Conventional payback period: years The conventional payback period ignores the time value of money, and this concerns Blue Hamster's CFO. He has now asked you to compute Delta's discounted payback period, assuming the company has a 10% 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 two decimal places. For full credit, complete the entire table. (Note: If your answer is negative, be sure to use a minus sign in your answer.) Year 3 Year 0 -$6,000,000 Year 1 $2,400.000 Year 2 55.100.000 52.100.000 Cash flow Discounted cash flow Cumulative discounted cash flow Discounted payback period: Is years Which version of a project's payback period should the CFO use when evaluating Project Delte, given its theoretical superiority? The regular payback period The discounted 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 in this example does the discounted payback period method fail to recognize due to this theoretical deficiency? $5,792,637 $3,759,579 $1,577,761 $1,974,455

Answer 1

Year 0 (6,000,000) (6,000,000) Year 1 2,400,000 (3,600,000) Year 2 5,100,000 1,500,000 E Year 3 2,100,000 3,600,000 2 Expected cash flow 3 Cumulative cash flow 4 5 Conventional payback period 1.7059 years ooo 9 Expected cash flow 10 Discounted Cash flow 11 Cumulative cash flow Year o (6,000,000) (6,000,000) (6,000,000) Year 1 2,400,000 2,181,818 (3,818,182) Year 2 5,100,000 4,214,876 396,694 Year 3 2,100,000 1,577,761 1,974,455 12 13 Conventional payback period 1.9059 years 14 Given discounted payback takes time value of money into consideration, that is a superior 16 approach to regular payback 17 15 18 19 Discounted payback fails to recognize value 1,974,455

D - E B Year o Year 1 Year 2 Year 3 -6000000 =B2 2400000 =B3+C2 5100000 =C3+D2 2100000 =D3+E2 2 Expected cash flow 3 Cumulative cash flow 4 5 Conventional payback period =1+(-C3/D2) years 8 9 Expected cash flow 10 Discounted Cash flow 11 Cumulative cash flow 12 13 Conventional payback period Year o =B2 =B9/(1+10%)^0 =B10 Year 1 =C2 =C9/(1+10%)^1 =B11+C10 Year 2 =D2 =D9/(1+10%)^2 =C11+D10 Year 3 =E2 =E9/(1+10%)^3 =D11+E10 =1+-C11/D10) years 14 15 16 Given discounted payback takes time value of money into consideration, that is a superior approach to regular payback 17 18 19 Discounted payback fails to recognize value =E11