12. The payback period

The payback method helps firms establish and identify a maximum acceptable payback period that helps in their capital budgeting decisions.

Consider the case of Cold Goose Metal Works:

Cold Goose Metal Works is a small firm, and several of its managers are worried about how soon the firm will be able to recover its initial investment from Project Sigmas expected future cash flows. To answer this question, Cold Gooses CFO has asked that you compute the projects payback period using the following expected net cash flows and assuming that the cash flows are received evenly throughout each year.

Complete the following table and compute the projects conventional payback period.(Note: For full credit, complete the entire table. Round the conventional payback period to the nearest two decimal places. If your answer is negative use a minus sign.)

The conventional payback period ignores the time value of money, and this concerns Cold Gooses CFO. He has now asked you to compute Sigmas discounted payback period, assuming the company has a 8% cost of capital. Complete the following table and perform any necessary calculations. (Note: Round the discounted cash flow values to the nearest whole dollar, and the discounted payback period to the nearest two decimal places. For full credit, complete the entire table. If your answer is negative use a minus sign.)

Which version of a projects payback period should the CFO use when evaluating Project Sigma, given its theoretical superiority?

A: The discounted payback period

B: The regular payback period

One theoretical disadvantage of both payback methodscompared to the net present value methodis that they fail to consider the value of the cash flows beyond the point in time equal to the payback period.

How much value does the discounted payback period method fail to recognize due to this theoretical deficiency?

A: $1,696,274

B: $1,250,286

C: $4,529,607

D: $2,916,953

Year o -$4,500,000 Year 1 $1,800,000 Year 2 $3,825,000 Year 3 $1,575,000 Expected cash flow Cumulative cash flow Conventional payback period: years Year o -$4,500,000 Year 1 $1,800,000 Year 2 $3,825,000 Year 3 $1,575,000 Cash flow Discounted cash flow Cumulative discounted cash flow Discounted payback period: $ years