Question

The Basics of Capital Budgeting: Payback Period

Payback Period

Payback period was the earliest ________ selection criterion.

-Select-
capital structure
financial statement
capital budgeting

The _________
-Select-
NPV
MIRR
IRR
payback

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-
shorter
longer

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-
less
equal
more

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-
project
capital
overhead

costs. However, the discounted payback still disregards cash flows

-Select-
during
before
beyond

the payback year. In addition, there is no specific payback rule to justify project acceptance. Both methods provide information about

-Select-
profitability
wealth
liquidity

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 -1,000 700 450 290 340
Project B -1,000 300 385 440 790

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

_______ years

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

_______ years

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

_______ years

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

_______ years

Answer 1

Payback period was the earliest (ANS 1) CAPITAL BUDGETING selection criterion.

The (ANS 2) PAYBACK 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 (ANS 3) SHORTER a project's payback, the better the project is. However, payback has 3 main disadvantages: (1) All dollars received in different years are given (ANS 4) EQUAL 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 (ANS 5) CAPITAL costs. However, the discounted payback still disregards cash flows

(ANS 6) BEYOND the payback year. In addition, there is no specific payback rule to justify project acceptance. Both methods provide information about (ANS 7) LIQUIDITY

Cash Flows of Project A:

Time	Cash Flow	Cumulative Cash Flow	Discounted Cash Flow	Cumulative Discounted Cash Flow
0	-1000	-1000	-1000	-1000
1	700	-300	654.205607	-345.794393
2	450	150	393.047428	47.253035
3	290	440	236.726384	283.979419
4	340	780	259.384372	543.363792

Payback Period = 1 year + (300/750) = 1.6667 years

Discounted Payback Period = 1 year + (345.794393/393.047428) = 1.8798 years

Cash Flows of Project B

Time	Cash Flow	Cumulative Cash Flow	Discounted Cash Flow	Cumulative Discounted Cash Flow
0	-1000	-1000	-1000	-1000
1	300	-700	280.373832	-719.626168
2	385	-315	336.273910	-383.352258
3	440	125	359.171066	-24.181192
4	790	915	602.687218	578.506026

Payback Period = 2 years + (315/440) = 2.7159 years

Discounted Payback Period = 3 years + (24.181192/602.687218) = 3.0401 years