7. 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 Betas 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. Round the conventional payback period to two decimal places. For negative values, be sure to include a minus sign in your answer. For full credit, complete the entire table.

	Year 0	Year 1	Year 2	Year 3
Expected cash flow	-4,500,000	$1,800,000	$3,825,000	$1,575,000
Cumulative cash flow
Conventional payback period:	years

The conventional payback period ignores the time value of money, and this concerns Cold Gooses CFO. He has now asked you to compute Betas 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 two decimal places. For negative values, be sure to include a minus sign in your answer. For full credit, complete the entire table.

	Year 0	Year 1	Year 2	Year 3
Cash flow	-4,500,000	$1,800,000	$3,825,000	$1,575,000
Discounted cash flow
Cumulative discounted cash flow
Discounted payback period:	years

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

The regular payback period

The discounted 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?

$1,696,274

$1,250,286

$4,529,607

$2,916,953