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Chapter 4: Q8BP (page 408)

Assume a \(90,000 investment and the following cash flows for two alternatives:

Year

Investment A

Investment B

1

\)25,000

\(40,000

2

30,000

40,000

3

25,000

28,000

4

19,000

--

5

25,000

--

a. Calculate the payback for investments A and B.

b. If the inflow in the fifth year for Investment A was \)25,000,000 instead of $25,000, would your answer change under the payback method?

Short Answer

Expert verified

Answer

  1. Project B has a lower payback period; therefore, it must be selected.

Cash inflow of the 5th year will not affect the answer under the payback method.

Step by step solution

01

Definition of Payback Period

Payback period is the matric used by the company under the capital budgeting methods which help them to selects the investment based on the time taken by the investment to cover the amount of potential investment through cash inflows.

02

Calculation of payback period for A and B investment

Investment A:

Paybackperiod=Periodbeforefullrecovery+AmountrecoveredinlastperiodCashflowinperiod=3+$10,000$19,000=3+0.5=3.5years

Investment B:

Paybackperiod=Periodbeforefullrecovery+AmountrecoveredinlastperiodCashflowinperiod=2+$10,000$28,000=2+0.4=2.4years

The business entity must select project B.

Working note:

Year

Cash inflow Investment A

Accumulated cash inflow for investment A

Cash inflow for Investment B

Accumulated cash inflow for investment B

1

$25,000

$25,000

$40,000

$40,000

2

30,000

$55,000

40,000

$80,000

3

25,000

$80,000

28,000


4

19,000


--


5

25,000


--


03

Change in cash inflow

The answer would not change under the payback method if the cash inflow in the 5th year were $25,000,000 instead of $25,000 because the initial investment cost will be covered in 3.5 years. Therefore, a change in the cash inflow of the 5th year would not affect the answer.

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Most popular questions from this chapter

Tom Cruise Lines Inc. issued bonds five years ago at $1,000 per bond. These bonds had a 25-year life when issued and the annual interest payment was then 15 percent. This return was in line with the required returns by bondholders at that point as described next:

Real rate of return ........................ 4%

Inflation premium ......................... 6

Risk premium .............................. 5

Total return ............................... 15%

Assume that five years later the inflation premium is only 3 percent and is appropriately reflected in the required return (or yield to maturity) of the bonds. The bonds have 20 years remaining until maturity. Compute the new price of the bond.

Using Table 10-1, assume interest rates in the market (yield to maturity) are 14 percent for 20 years on a bond paying 10 percent.

a. What is the price of the bond?

b. Assume five years have passed and interest rates in the market have gone down to 12 percent. Now, using Table 10-2 for 15 years, what is the price of the bond?

c. What would your percentage return be if you bought the bonds when interest rates in the market were 14 percent for 20 years and sold them 5 years later when interest rates were 12 percent?

Question: Betty Bronson has just retired after 25 years with the electric company. Her total pension funds have an accumulated value of $180,000, and her life expectancy is 15 more years. Her pension fund manager assumes he can earn a 9 percent return on her assets. What will be her yearly annuity for the next 15 years?

Assume a \(250,000 investment and the following cash flows for two products:

Year

Product X

Product Y

1

\)90,000

$50,000

2

90,000

80,000

3

60,000

60,000

4

20,000

70,000

Which alternatives would you select under the payback method?

Debby鈥檚 Dance Studios is considering the purchase of new sound equipment that will enhance the popularity of its aerobics dancing. The equipment will cost \(27,900. Debby is not sure how many members the new equipment will attract, but she estimates that her increased annual cash flows for each of the next five years will have the following probability distribution. Debby鈥檚 cost of capital is 15 percent.

Cash Flow Probability

\)4,570 ........................ 0.1

5,550 ........................ 0.3

7,400 ........................ 0.4

9,930 ........................ 0.2

a. What is the expected value of the cash flow? The value you compute will apply to each of the five years.

b. What is the expected net present value?

c. Should Debby buy the new equipment?
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