Question

Compute the payback period for each of these two separate investments ( Round the payback period to two decimals) :A. A new operating system for an existing machine is expected to cost $520,000 and have a useful life of six years, the system yields an incremental after-tax income of $150,000 each year after deducting its straight-line depreciation. The predicted salvage value of the system is $10,000.B. A machine cost $380,000, has a $20,000 salvage value, is expected to last eight years, and will generate an after-tax income of $60,000 per year after straight-line depreciation.

Answer 1

Answer:

Payback period for the new operating system is 3.2 years

Payback period for the new machine is 4.53 years

Explanation:

Hi, first, we need to finf the depreciation for both investments, for A (operating system) that is 520,000/6 = 86,667 and for the new machine is 380,000/8 = 47,500.

This is important since depreciation is a non-monetary expense, therefore you don´t actually pay it, its sole use is to cut taxes.

Now, assuming that there will be no payment (deduction) in taxes when the machine or the operating system is sold (in 6 years for the system, in 8 years for the machine) and that the annual cash flow for the operating system is $236,667 (that is $150,000+$86,667) and for the new machine is $107,500 (because the annual after tax income is $60,000 + depreciation which is $47,500), the payback period for the operating system is 3.20 years and for the machine is 4.53 years.

In order to find the payback period for each of the investments, we need to add the consecutive cash flow until it turns positive, and then find the fraction. For more information on how to solve this problem, please relate to the attached excel sheet.

Best of luck.

Download xlsx