FED Construction Co. is considering a new inventory system that will cost $975,000. The system is expected to generate positive cash flows over the next four years in the amounts of $100,000 in year one, $205,000 in year two, $300,000 in year three, and $150,000 in year four. FED's required rate of return is 10%.
What is the payback period of this project?
The payback period is a capital budgeting technique used for evaluating projects. It determines the period within which the initially invested amount will be covered in the form of cash inflows. However, it is less reliable as it does not consider the time value of money.
Answer and Explanation:
First, we will find accumulated cash flows:
|Year||Cash flows||Accumulated cash flows|
|2||$205,000||$305,000 ($100,000 + $205,000)|
|3||$300,000||$605,000 ($305,000 + $300,000)|
|4||$150,000||$755,000 ($605,000 + $150,000)|
The given initial outlay for the new inventory system is $975,000. But as we can see that within 4 years only $755,000 could be recovered whereas the initial outlay is $975,000. So, to completely recover the initial outlay, the firm will need more time. Therefore, the payback period is will be greater than the project life i.e > 4 years.
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from Introduction to Management: Help and ReviewChapter 16 / Lesson 12