Question

The Dammon Corp. has the following investment opportunities: Machine A Machine B Machine C In. Inv. (10,000) (22,500) (35,500) years Inflows Inflows Inflows 1 6,000 14,000 - 2 2,900 7,500 35,000 3 3,500 5,000 6,000 4 - 1,500 20,000 Under the payback method and assuming these machines are mutually exclusive, which machine(s) would Dammon Corp. choose? Seleccione una: Machines A and C Machine B Machine C Machines B and C Machine A

Answer 1

Payback Period calculation gives us an idea that how long it will take for a project to recover the initial investment.

We can use cumulative cash flow table to see that when the cumulative cash flow is equal to zero (or non-negative) for Machine A

Year	Cash Flow	Cumulative Cash Flow
0	-$10,000	-$10,000
1	$6,000	-$4,000
2	$2,900	-$1,100
3	$3,500	$2,400

We can see from above table that at the end of year 2 the initial investment is not recovered, so the payback period is greater than 2 year and can be calculated in following manner

Payback Period for Machine A = last year of negative cumulative cash flow + (absolute value of last year of negative cumulative cash flow / Cash flow of next year after negative Cumulative Cash Flow)

= 2 + ($1,100/ $3,500) = 2 + 0.31 = 2.31 years

The payback period for Machine A is 2.31 years.

Payback period for Machine B

Year	Cash Flow	Cumulative Cash Flow
0	-$22,500	-$22,500
1	$14,000	-$8,500
2	$7,500	-$1,000
3	$5,000	$4,000
4	$1,500	$5,500

We can see from above table that at the end of year 2 the initial investment is not recovered, so the payback period is greater than 2 year and can be calculated in following manner

Payback Period for Machine B = last year of negative cumulative cash flow + (absolute value of last year of negative cumulative cash flow / Cash flow of next year after negative Cumulative Cash Flow)

= 2 + ($1,000/ $5000) = 2 + 0.2 = 2.20 years

The payback period for Machine B is 2.20 years.

Payback period for Machine C

Year	Cash Flow	Cumulative Cash Flow
0	-$35,500	-$35,500
1	$0	-$35,500
2	$35,000	-$500
3	$6,000	$5,500
4	$20,000	$25,500

We can see from above table that at the end of year 2 the initial investment is not recovered, so the payback period is greater than 2 year and can be calculated in following manner

Payback Period for Machine C = last year of negative cumulative cash flow + (absolute value of last year of negative cumulative cash flow / Cash flow of next year after negative Cumulative Cash Flow)

= 2 + ($500/ $6000) = 2 + 0.08 = 2.08 years

The payback period for Machine C is 2.08 years.

Under the payback method and assuming these machines are mutually exclusive, Dammon Corp. will choose Machine C as the payback period is lowest for this machine.

Therefore correct answer is option: Machine C