Blue Hamster Manufacturing Inc. is a small firm, and several of its managers are
ID: 2766450 • Letter: B
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 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. The conventional payback period ignores the time value of money, and this concerns Blue Hamster's CFO. He has now asked you to compute Sigma's discounted payback period, assuming the company has a 8% 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 decimal places. For full credit, complete the entire table. Which version of a project's payback period should the CFO use when evaluating Project Sigma, given its theoretical superiority? The regular payback period The discounted payback period One theoretical disadvantage of both payback methods-compared to the net present value method-is that they fail to consider the value of the cash flows beyond the point in time equal to the payback period. How much value does the discounted payback period method fail to recognize due to this theoretical deficiency? $5,032,896 $3,241,058 $1,884,748 $1,389,206Explanation / Answer
Details
Year 0
Year 1
Year 2
Year 3
Expected cash flows
$ 5,000,000
$ 2,000,000
$ 4,250,000
$ 1,750,000
Cumulative cash flow
$ -
$ 2,000,000
$ 6,250,000
$ 8,000,000
Coventional payback period
1 year 8 months
Pay back period = 1 completed year + ($3,000,000/$4,250,000)*12
= 1 year 8 months
Detailed cumulative cash flows are given below:
Details
Year 0
Year 1
Year 2
Year 3
Expected cash flows
$ 5,000,000
$ 2,000,000
$ 4,250,000
$ 1,750,000
Cumulative cash flow
$ 1,851,860
$ 5,495,555
$ 6,884,758
Coventional payback period
1 year 10 months
Pay back period = 1 completed year + ($5,000,000-$1,851,860) /$3,643,695)*12
= 1 year 10 months
Detailed calculation for the baove table is given below.
Details
Year 0
Year 1
Year 2
Year 3
Expected cash flows
$ 5,000,000
$ 2,000,000
$ 4,250,000
$ 1,750,000
Disc. at 8%
0.00000
0.92593
0.85734
0.79383
Disc. Cash flows
$ 1,851,860
$ 3,643,695
$ 1,389,203
Cumulative cash flow
$ 1,851,860
$ 5,495,555
$ 6,884,758
Coventional payback period
1 year 10 months
The discounted payback period should the CFO used to evalute the project because it has absolute figures of dollars in real terms.
The correct option is $1,884,748 which is the disc. Cash flows beyond the payback period.
Details
Year 0
Year 1
Year 2
Year 3
Expected cash flows
$ 5,000,000
$ 2,000,000
$ 4,250,000
$ 1,750,000
Cumulative cash flow
$ -
$ 2,000,000
$ 6,250,000
$ 8,000,000
Coventional payback period
1 year 8 months