Question

Blue Hamster Manufacturing 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 Sigma's expected future cash flows. To answer this question, Blue Hamster's CFO has asked that your compute the project's payback period using the following the expected net cash flows and assuming that the cash flows are received evenly throughout each year.
Completed the following table and compute the projects conventional payback period.

Year 0 Year 1 Year 2 Year 3
Expected cash flow -6m 2.4m 5.1m 2.1m
Cumulative cash flow
Conventional payback period
The conventional payback period ignores the time value of money, and this concerns Blue Hamsters CFO. He has now asked you to compute Sigma's discounted payback period, assuming the company has 9% 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 decimals places,

year 0 year 1 year 2 year 3
Cash Flow -6m 2.4m 5.1m 2.1m
Discounted cash flow
Cumulative discounted cash flow
Discounted payback period
Which version of a projects' payback period should the CFO use when evaluting the project sigma, given its theorectical superiority?

A) The regular payback period

B)The discounted payback period

One theoretical disadvantages of both payback methods- compared to the net present value method- is that they fill to consider the value of the cash flows beyond the point in time equal to payback period.

How much values does the discounted payback period method fail to recognize due to this theoretical definency?
A. 5,914, 153
B. 2,115,988
C. 1,621,585
D. 3,823,240

Answer 1

Answer and Explanation:

1. The computation is shown below:-

                                   Year 0               Year 1       Year 2       Year 3

Expected Cash flow ($6,000,000)  $2,400,000  $5,100,000  $2,100,000

Cumulative Cash

flow                          ($6,000,000)  ($3,600,000)  $1,500,000 $3,600,000

Conventional Payback

Period                                                     1                      0.71

For the computation of cumulative cash flow for the first year, we simply deduct expected cash flow the Year 0 from Year 1 for the second year we added the Cumulative cash flow of year 1 with the expected cash flow of year 2 and for third year we added Expected cash flow of year 3 with a cumulative cash flow of year 2

and for conventional payback period for year 1

Conventional Payback Period = 1 + ($3,600,000 ÷ $5,100,000)

= 1 + 0.71

= 1.71 year

2. The computation is shown below:-

                                       Year 0               Year 1       Year 2       Year 3

Expected Cash flow ($6,000,000)  $2,400,000  $5,100,000  $2,100,000

Discount factor at

9%                                   1                    0.91743      0.84168        0.77218

Discounted Cash

Flow                        ($6,000,000)   $2,201,835   $4,292,568  $1,621,585

Cumulative Discounted

Cash Flow               ($6,000,000)   ($3,798,165)   $494,403   $2,115,988

Discounted Payback

Period                                                         1               0.88

Conventional Payback Period = 1 + ($3,798,165 ÷ $4,292,568)

= 1 + 0.88

= 1.88 year

3. B. Discounted Payback Period.

The payback period is the period in which it tells in how many years the initial investment amount could be recovered and the discounted payback period is the period in which the cash outflows and the cash inflows are discounted

4. B. $2,115,988 which shows the more than the higher the cash inflow above the project investment value.