Question

A certain project with the following cash flows has been proposed.  The board uses the Payback method and the Discounted Payback method will approve only projects that pay back within 3.5 years.

Year 0             Initial investment                               700,000

Year 1             Income                                              275,000

Year 2             Income                                              189,000

Year 3             Income                                              78,000

Year 4             Income                                              322,000

Discount  rate                                                           7%

When will it pay back using Payback? _________   Is this a Go or a No Go? ____________

When will it pay back using Discounted Payback?  ________  Is it a Go or a No Go? _____________

Answer 1

1.Cumulative cash flow in year 1= $275,000

Cumulative cash flow in year 2= $464,000

Cumulative cash flow in year 3= $542,000

Payback period= full years until recovery + unrecovered cost at the start of the year/ cash flow during the year

= 3 years +($700,000 - $542,000)/ $322,000

= 3 years + $158,000/ $322,000

= 3 years + 0.49

= 3.49 years.

It is a Go since the payback period is within 3.5 years.

2.Cumulative discounted cash flow in year 1= $257,009.35

Cumulative discounted cash flow in year 2= $165,079.92

Cumulative discounted cash flow in year 3= $63,673.47

Cumulative discounted cash flow in year 4= $245,651.51

Discounted payback period= full years until recovery + unrecovered cost at the start of the year/ discounted cash flow during the year

= 3 years + ($700,000 - $485,762.74)/ $245,651.51

= 3 years + $214,237.26/ $245,651.51

= 3 years + 0.87

= 3.87 years.

It is a No Go since the discounted payback period is not within 3.5 years.