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 Cold Goose Metal Works Inc.: 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. For full credit, complete the entire table. Year 0 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 Cold Goose's CFO. He has now asked you to compute Beta's discounted payback period, assuming the company has a 890 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.

Answer 1

Year	Cash Flow	Cumulative Cash Flow
0	-5,000,000	-5,000,000
1	2,000,000	-3,000,000
2	4,250,000	1,250,000
3	1,750,000	3,000,000

Conventional Payback Period = 1 + 3,000,000/4,250,000

= 1.71 years

Discounted Payback:

Year	Cash Flow	Present Value Factor	Discounted Cash Flow	Cumulative Cash Flow
0	-5,000,000	1	-5,000,000	-5,000,000
1	2,000,000	0.926	1,852,000	-3,148,000
2	4,250,000	0.857	3,642,250	494,250
3	1,750,000	0.794	1,389,500	1,883,750

Discounted Payback period = 1+ 3,148,000/3,642,250

= 1.86 years

While evaluating beta, the regular payback period give bots theoretical superiority

Value not recognised by discounted payback period = Cash flow of year 3, since not considered in calculation

= $1,884,748 (approx.)