SK Manufacturing Company uses discounted payback period to evaluate investments in capital assets. The company expects the following annual cash flows from an investment of $3,500,000:
No salvage/residual value is expected. The company’s cost of capital is 12%.
- Compute discounted payback period of the investment.
- Is the investment desirable if the required payback period is 4 years or less.
(1) Computation of discounted payback period:
In order to compute the discounted payback period, we need to compute the present value of each year’s cash flow.
Discounted payback period = Years before full recovery + (Unrecovered cost at start of the year/Cash flow during the year)
= 5 + (**$255,500/$456,300)
= 5 + 0.56
= 5.56 years
*Value from “present value of $1 table”.
**Unrecovered cost at start of 6th year = Initial cost – Cumulative cash inflow at the end of 5th year
= $3,500,000 – $3,244,500
Because the discounted payback period is longer than 4-year period, this investment is not desirable.