Question

A public works department in a metropolitan area is looking into buying a major equipment to enhance productivity. The initial cost is estimated to be $600,000. It is projected that new equipment will help save $250,000 the first year and decrease gradually by $50,000 for the next four years. Determine the payback period for this equipment purchase.
Select the most appropriate answer from the choices below. No partial credit. Show all work, no credit if work not shown (not a guessing game).

A. The payback is approximately 1 year

B. The payback is approximately three years

C. The payback is approximately six years

D. None of the above

Answer 1

Answer:

B. The payback is approximately three years

Explanation:

The computation of payback period for this equipment purchase is shown below:-

Year              Cash flow          Cumulative cash flow

0                   -$600,000             -$600,000

1                     $250,000              -$350,000

2                    $200,000              -$150,000

                 ($250,000 - $50,000)

3                    $150,000                  0

                 ($200,000 - $50,000)

4                    $100,000                $100,000

                  ($150,000 - $50,000)

5                    $50,000                  $150,000

         ($100,000 - $50,000)

Here, Cumulative cash flow in the year o is -$600,000 and as we can see that cumulative cash flow in year 3 is 0.

Therefore the payback period lies in 3 years.