7 The payback period The payback method helps firms establis

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 Cute Camel Woodcraft Company: Cute Camel Woodcraft Company 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 Beta\'s expected future cash flows. To answer this question, Cute Camel\'s CFO has asked that you compute the project\'s 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 project\'s conventional payback period. For full credit, complete the entire table. Year 0 Year 1 Year 2 Year 3 4,500,000 $1,800,000 $1,575,000 Expected cash flow Cumulative cash flow $3,825,000 Conventional payback period:

Solution

Conventional payback period = 1 year + (-2700000 - 0) / (-2700000 - 1125000)*1

= 1 + 0.706

= 1.71 years

Discounted Payback period = 1 year + (-2863636-0) / (-2863636-297521)

= 1.91 years

The CFO should use the Discounted payback period when evaluating Project Beta, because the discounted payback period takes the expected cash flows’ time value of money effects into account and the regular payback period does not.

The discounted payback peirod method fail to recognize due to this theoretical deficiency

The managers are failing to consider that beta is expected to generate another $1480842 in shareholder wealth.

	Year 0	Year 1	Year 2	Year 3
Expected cash flow	-4500000	1800000	3825000	1575000
cumulative cash flow	-4500000	-2700000	1125000	2700000
Conventional payback peirod	1.71