Question

The director of capital budgeting for Big Sky Health System, Inc. has estimated the following cash flows for a new service and has a cost of capital of 8%. What is the project’s payback period?

year annual cash flows project cost of capital

0 $ (125,000) 8%

1 $ 75,000

2 $ 55,000

3 $ 25,000

Choice: 4 years Choice: Not enough information to tell. Choice: 1.91 years Choice: 2.4 years

Answer 1

Year	0	1	2	3
Cashflow(in $)	(125,000)	75,000	55,000	25,000
Cumulative Cashflow(in $)	(125,000)	(50,000)	5,000	30,000

Payback Period = A + (B/C)

where

A -  last time period where the cumulative cash flow was negative = 1

B - absolute value of the CCF at the end of that period A = 50000

C - value of the CCF in the next period after A = 55000

Payback Period = 1+(50000/55000)

= 1.91 years