FED Construction Co. is considering a new inventory system that will cost $750,000. The system is...

Question:

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?

Payback Period:

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.


Learn more about this topic:

Loading...
Payback Analysis: Formula & Example

from Introduction to Management: Help and Review

Chapter 16 / Lesson 12
26K

Related to this Question

Explore our homework questions and answers library