Question

12. 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: Green Caterpillar Garden Supplies 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.(Note: For full credit, complete the entire table. Round the conventional payback period to the nearest two decimal places. If your answer is negative use a minus sign.) Year O Year 2 Year 3 Year 1 $2,400,000 -$6,000,000 $5,100,000 $2,100,000 Expected cash flow Cumulative cash flow Conventional payback period: years

Answer 1

Calculation of payback period for Project Alpha
Year	Cashflows ($)	Cumulative cashflows ($)
0	-6000000	-6000000
1	2400000	-3600000
2	5100000	1500000
3	2100000	3600000
Payback period= A+ (B/C)
where,
A= last period number with negative cumulative cashflows
B= absolute value of cumulative net cashflow at the end of period A
C= total cash inflow during the period following period A
Payback period= 1+(3600000/5100000)
		1.71 years
Calculation of discounted payback period for Project Alpha
Year	Cashflows ($)	Discounting factor @ 10%	Discounted cashflow ($)	Cumulative discounted cashflow ($)
0	-6000000	1	-6000000.00	-6000000.00
1	2400000	0.909090909	2181818.18	-3818181.82
2	5100000	0.826446281	4214876.03	396694.21
3	2100000	0.751314801	1577761.08	1974455.30
		NPV	1974455
Discounted Payback period= A+ (B/C)
where,
A= last period number with negative discounted cumulative cashflows
B= absolute value of discounted cumulative net cashflow at the end of period A
C= discounted cash flow during the period after period A
Discounted Payback period= 1+(3818181.82/4214876.03)
		1.91 years
Given its theoretical superiority, the CFO should use "Discounted payback period" while evaluating Project Alpha
Answer: Option A
$1974455 is the value the discounted payback period method fail to recognise due to its theoretical deficiency (See table above)
Answer: Option D