Question

The Basics of Capital Budgeting: Payback

Payback period was the earliest -Select-capital structurefinancial statementcapital budgetingCorrect 1 of Item 1 selection criterion. The -Select-NPVMIRRIRRpaybackCorrect 2 of Item 1 is a "break-even" calculation in the sense that if a project's cash flows come in at the expected rate, the project will break even. The equation is:

The -Select-shorterlongerCorrect 3 of Item 1 a project's payback, the better the project is. However, payback has 3 main disadvantages: (1) All dollars received in different years are given -Select-lessequalmoreCorrect 4 of Item 1 weight. (2) Cash flows beyond the payback year are ignored. (3) The payback merely indicates when a project's investment will be recovered. There is no necessary relationship between a given payback and investor wealth maximization.

A variant of the regular payback is the discounted payback. Unlike regular payback, the discounted payback considers -Select-projectcapitaloverheadCorrect 5 of Item 1 costs. However, the discounted payback still disregards cash flows -Select-duringbeforebeyondCorrect 6 of Item 1 the payback year. In addition, there is no specific payback rule to justify project acceptance. Both methods provide information about -Select-profitabilitywealthliquidityCorrect 7 of Item 1 and risk.

Quantitative Problem: Bellinger Industries is considering two projects for inclusion in its capital budget, and you have been asked to do the analysis. Both projects' after-tax cash flows are shown on the time line below. Depreciation, salvage values, net operating working capital requirements, and tax effects are all included in these cash flows. Both projects have 4-year lives, and they have risk characteristics similar to the firm's average project. Bellinger's WACC is 7%.

	0		1		2		3		4
Project A	-1,050		650		395		220		270
Project B	-1,050		250		330		370		720

What is Project A's payback? Do not round intermediate calculations. Round your answer to four decimal places.

years

What is Project A's discounted payback? Do not round intermediate calculations. Round your answer to four decimal places.

years

What is Project B's payback? Do not round intermediate calculations. Round your answer to four decimal places.

years

What is Project B's discounted payback? Do not round intermediate calculations. Round your answer to four decimal places.

years

Answer 1

DS fx -SUM(D3:07) C B D 1 Project A year pv@7% Cash flows (1,050.00) $ 650.00 $ 395.00 220.00 $ 270.00 Present value Cumulative cash flows Cumulative Discounted cash flows 1.0000 $ (1,050.00) $ (1,050.00) $ (1,050.00) 0.9346 $ 607.48 $ (400.00) $ (442.52) 0.8734 $ 345.01 $ (5.00) $ (97.52) 0.8163 $ 179.59 $ 215.00 $ 82.07 0.7629 $ 205.98 $ 485.00 $ 288.05 $ 288.05 NPV Payback Period 2+5/220 Discounted Payback 2+97.52/179.59 2.0227 Years 2.5430 Years 12 13 Project B 14 year 15 Cash flows pv@7% (1,050.00) 250.00 330.00 370.00 720.00 NPV Present value Cumulative cash flows Cumulative Discounted cash flows 1.0000 $ (1,050.00) $ (1,050.00) $ (1,050.00) 0.9346 $ 233.64 $ (800.00) $ (816.36) 0.8734 $ 288.23 $ (470.00) $ (528.12) 0.8163 $ 302.03 $ (100.00) $ (226.09) 0.7629 $ 549.28 $ 620.00 $ 323.19 $ 323.19 Payback Period 3+100/720 Discounted Payback 3+226.09/549.28 3.1389 Years 3.4116 Years

f =SUM(D3:07) с DS А 1 Project A 2 year 30 pv@7% Cash flows -1050 650 395 =C3/1.07 =C4/1.07 =C5/1.07 =C6/1.07 NPV Present value =B3*C3 =B4*C4 =B5*C5 =B6*C6 =B7*C7 =SUMD3:07) Cumulative cash flows Cumulative Discounted cash flows =B3 =D3 =E3+B4 =F3+D4 =E4+B5 =F4+D5 =E5+B6 =F5+D6 =E6+B7 |=F6+D7 Payback Period 2+5/220 Discounted Payback 2+97.52/179.59 =2+5/220 Years =2+97.52/179.59 Years 11 pv@7% 13 Project B 14 year 15 O 16 1 Cash flows -1050 250 C15/1.07 =C16/1.07 =C17/1.07 =C18/1.07 NPV Present value =B15*C15 =B16*C16 =B17*C17 =B18*C18 =B19*C19 =SUM(D15:D19) Cumulative cash flows Cumulative Discounted cash flows =B15 =D15 =E15+B16 F15+D16 =E16+B17 =F16+D17 =E17+B18 =F17+D18 =E18+B19 =F18+D19 Payback Period 3+100/720 =3+100/720 Years Discounted Payback 3+226.09/549.28 =3+226.09/549.28 Years