Problem-3 (discounted payback period method)
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%.
Required:
- Compute discounted payback period of the investment.
- Is the investment desirable if the required payback period is 4 years or less.
Solution:
(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:
= Initial cost – Cumulative cash inflow at the end of 5th year
= $3,500,000 – $3,244,500
= $255,500
(2) Conclusion:
Because the discounted payback period is longer than 4-year period, the investment is not desirable.
5 Comments on Problem-3 (discounted payback period method)
What is the difference between simple payback period and discounted payback period? Which one is the best?
Simple payback period method does not considers the time value of money whereas discounted payback period method does. Both are used to analyze capital investments but discounted payback method is sometime preferred by managers because it takes into account the time value of money.
You cannot devide 255500/456300
Because the interest is continuous, so it 5.56 atleast, 5.56 < X < 6
good problem
What do you do when you have been given a residue value when calculating payback period