Question

A machine can be purchased for $180,000 and used for five years, yielding the following net incomes. In projecting net incomes, straight-line depreciation is applied using a five-year life and a zero salvage value. Net income Year 1 $12,100 Year 2 $30,100 Year 3 $69,000 Year 4 $45,300 Year 5 $120,400 Compute the machine's payback period (ignore taxes). (Round your intermediate calculations to 3 decimal places and round payback period answer to 3 decimal places.) Year Net Income Depreciation Net Cash Cumulative Cash Flow $ (180,000) $ (180,000) $ 1 2 12,100 30,100 69,000 45,300 120,400 4 Payback period =

Answer 1

Answer)

Payback Period: It is the time required to recover the initial investment on a project. This concept is used in capital budgeting proposals wherein initial cash outlay will be made today which results in cash inflows over several years. Lower the payback period higher will be the return from the capital investment. One of the shortcomings of this concept is that it ignores the time value of money.

Year	Net Income (A)	Depreciation (B)	Net Cash Flow (A) + (B)	Cumulative Cash flow
0			-$ 180,000	-$ 180,000
1	$ 12,100	$ 36,000	$ 48,100	-$ 131,900
2	$ 30,100	$ 36,000	$ 66,100	-$ 65,800
3	$ 69,000	$ 36,000	$ 105,000	$ 39,200
4	$ 45,300	$ 36,000	$ 81,300	$ 120,500
5	$ 120,400	$ 36,000	$ 156,400	$ 276,900

Steps to calculate Payback period:

Step 1: Ascertain the year in which the cumulative cash flow is negative for last time (i.e. Year 2 in the given example).

Step 2: Divide the absolute value of cumulative cash flow of the year in step 1 and divide it by the amount of Net cash flow of the immediately succeeding year.

           = $ 65,800/ $ 105,000

          = 0.6266666 or 0.627 (rounded off)

Step 3: Add the value calculated in Step 1 and Step 2 to get the payback period

Payback period = Value in Step 1 + Value in Step 2

                            = 2 years + 0.627 years

                            = 2.627 years

Therefore, payback of the machine is 2.627 years

Working Note:

Calculation of depreciation each year using Straight Line Method

Depreciation per year = (Original Cost –Scrap Value)/ Number of years of useful life

                                        = ($ 180,000 – 0)/ 5 years

                                        = $ 36,000

Therefore, depreciation allowed in each of the 5 years will be $ 36,000.