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:

1. Compute discounted payback period of the investment.
2. 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 year = 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, this investment is not desirable.