4. 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 Inc.: Cold Goose Metal Works Inc. 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 Beta's expected future cash flows. To answer this question, Cold Goose's CFO has asked that you compute the project's 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 project's conventional payback period. For full credit, complete the entire table. (Note: Round the conventional payback period to the nearest two decimal places. If your answer is negative use a minus sign.) Year o Year 3 Year 1 $1,800,000 Year 2 $3,825,000 Expected cash flow -$4,500,000 $1,575,000 $ Cumulative cash flow Conventional payback period: years The conventional payback period ignores the time value of money, and this concerns Cold Goose's CFO. He has now asked you to compute Beta's discounted payback period, assuming the company has a 8% cost of capital. Complete the following table and perform any necessary calculations. 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. (Note: If your answer is negative use a minus sign.) 5. The NPV and payback period What information does the payback period provide? A project's payback period (PB) indicates the number of years required for a project to recover its initial investment using its operating cash flows. As the theoretical soundness of the conventional (undiscounted) PB technique was criticized, the model was modified to incorporate the time value of money-adjusted operating cash flows to create the discounted payback method. While both payback models continue to reflect faulty ranking criteria, they do provide important (useful information regarding a project's liquidity and riskiness. risky than cash flows received in the near-term-which suggests that the payback In general, cash flows expected in the distant future are period can also serve as an indicator of project risk. Suppose you are evaluating a project with the expected future cash inflows shown in the following table. Your boss has asked you to calculate the project's net present value (NPV). You don't know the project's initial cost, but you do know the project's regular, or conventional, payback period is 2.50 years. Year Cash Flow Year 1 $300,000 Year 2 400,000 Year 3 475,000 Year 4 400,000 If the project's weighted average cost of capital (WACC) is 7%, the project's NPV (rounded to the nearest dollar) is: O $385,149 O $462,179 O $365,892 O $423,664 Which of the following statements indicate a disadvantage of using the regular payback period (not the discounted payback period) for capital budgeting decisions? Check all that apply. The payback period does not take the project's entire life into account. The payback period does not take the time value of money into account. The payback period is calculated using net income instead of cash flows. 3. Net present value method Consider the case of Sutherland Industries: Sutherland Industries is evaluating a proposed capital budgeting project that will require an initial investment of $136,000. The project is expected to generate the following net cash flows: Year Cash Flow $40,000 Year 1 Year 2 $50,900 $46,200 Year 3 Year 4 $43,900 Assume the desired rate of return on a project of this type is 9%. What is the net present value of this project? (Note: Do not round your intermediate calculations.) -$7,244.50 $15,845.40 $10,313.50 $18,304.10 Suppose Sutherland Industries has enough capital to fund the project, and the project is not competing for funding with other projects. Should Sutherland Industries accept or reject this project? Reject the project Accept the project