FED Construction Co. is considering a new inventory system that will cost $750,000. The system is expected to generate positive cash flows over the next four years in the amounts of $350,000 in year one, $325,000 in year two, $150,000 in year three, and $180,000 in year four. FED's required rate of return is 8%.
What is the payback period of this project?
The payback period is the number of periods a project takes in order to generate enough cumulative cash flows to cover the initial cost of the project. There are two types of payback analysis: simple payback and discounted payback.
Answer and Explanation:
The payback period is the number of years until the project generates enough cumulative cash flows to cover the initial cost of the project. The initial cost is 750,000. We first compute the cumulative cash flows from the project:
- year 1: 350,000
- year 2: 350,000 + 325,000 = 675,000
- year 3: 675,000 + 150,000 = 825,000
Thus by year 3, the project has generated enough cumulative cash flows to cover the initial cost. The payback period is:
- 2 + (750,000 - 675,000) / 150,000 = 2.5
That is, the payback period is 2.5 years.
Become a member and unlock all Study Answers
Try it risk-free for 30 daysTry it risk-free
Ask a question
Our experts can answer your tough homework and study questions.Ask a question Ask a question
Learn more about this topic:
from Introduction to Management: Help and ReviewChapter 16 / Lesson 12