Question

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 Alpha'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. Year O -4,000,000 Year 1 $1,600,000 Year 2 $3,400,000 Year 3 $1,400,000 Expected cash flow Cumulative cash flow Conventional payback period: The conventional payback period ignores the time value of money, and this concerns Blue Hamster's CFO. He has now asked you to compute Alpha'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. For full credit, complete the entire table. Year o -4,000,000 Year 1 $1,600,000 Year 2 $3,400,000 Year 3 $1,400,000 Cash flow Discounted cash flow Cumulative discounted cash flow Discounted payback period: Which version of a project's payback period should the CFO use when evaluating Project Alpha, 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 does the discounted payback period method fail to recognize due to this theoretical deficiency? $3,942,769 $1,410,659 $2,548,947 $1,081,057 O

Answer 1

C D 1 2 3 Expected cash flow Cumulative cash flow Year o (4,000,000) (4,000,000) Year 1 1,600,000 (2,400,000) Year 2 3,400,000 1,000,000 Year 3 1,400,000 2,400,000 5 Conventional payback period 1.7059 years 9 Expected cash flow 10 Discounted Cash flow 11 Cumulative cash flow Year o (4,000,000) (4,000,000) (4,000,000) Year 1 1,600,000 1,467,890 (2,532,110) Year 2 3,400,000 2,861,712 329,602 Year 3 1,400,000 1,081,057 1,410,659 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 1,410,659

D Year 2 Year 0 Year 1 Year 3 -4000000 =B2 1600000 =B3+C2 3400000 =C3+D2 1400000 =D3+E2 2 Expected cash flow 3 Cumulative cash flow 4 5 Conventional payback period =1+(-C3/D2) years ooo Year 0 9 Expected cash flow 10 Discounted Cash flow 11 Cumulative cash flow =B2 =B9/(1+9%)^0 =B10 Year 1 =C2 =C9/(1+9%)^1 =B11+C10 Year 2 =D2 =D9/(1+9%)^2 =C11+D10 Year 3 =E2 =E9/(1+9%)^3 =D11+E10 13 Conventional payback period =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 20 =E11