Question

Bixby Inc. is evaluating expansion into a new market. The firm estimates an after-tax cost of $1,400,000 and forecast that such an investment will yield after-tax cash flows for 5 years: $600,000 in year 1, $700,000 in year 2, $700,000 in year 3, $200,000 in year 4, and $300,000 in year 5. If the CFO of Bixby has set a required payback period of 2.5 years, what is the project’s actual payback period (in years) and should they pursue it?

Answer 1

Payback period is the time taken by the cash inflows to re-earn the initial invested amount.

For our question,

CF Yr 0: -1,400,000. Cumulative cash flow = -1,400,000

CF Yr 1: 600,000. Cumulative cash flow till date = -1,400,000 + 600,000 = -800,000

CF Yr 2: 700,000. Cumulative cash flow till date = -800,000 + 700,000 = -100,000

CF Yr 3: 700,000. Cumulative cash flow till date = -1,00,000 + 700,000 = 600,000

CF Yr 4: 200,000. Cumulative cash flow till date = 600,000 + 200,000 = 800,000

CF Yr 5: 300,000. Cumulative cash flow till date = 800,000 + 300,000 = 1,100,000

Now, cumulative cash flow turns positive in year 3. This means the payback period is between Year 2 and Year 3.

At the end of Year 2, cumulative cash flow was -100,000. This means you required just 100,000 more to complete the payback (re-earn invested amount of $1,400,000). However, year 3 cash flow = $700,000.

Payback period = 2 + (100,000/700,000) = 2.14 years (2 represents the complete 2 years when the cumulative cash flow was negative).

Since, the payback calculated is less than 2.5 required payback, Bixby Inc. should pursue the project.