Acme, Inc. is considering a four-year project that has an initial outlay or cost of $80,000. The respective future cash inflows for years 1, 2, 3 and 4 are: $40,000, $40,000, $30,000 and $30,000.
Acme uses the discounted payback period method and has a discount rate of 12%. Will Acme accept the project if it’s payback period is two and one-half years?
What will be an ideal response?
ANSWER
Answer: We first discount all after-tax cash inflows, which gives us after-tax cash inflows of $35,714.29, $31,887.76, $21,353.41, and $19,065.54. After two years or 24 months, we will have paid back $67,602.04 leaving $12,397.95 to pay back in after-tax cash flows in the third year. Since we get $21,353.41 in the third year, the rule of thumb is to divide what is needed by the cash inflows we will get next period and add it to the number of previous periods of cash inflows, e.g., (12,397.95 divided by $21,353.41) + 2. Doing this gives 2.581. Thus, the payback period is about 2.58 years (or in months it is 2.581 × 12 = 30.967 months). Acme does not accept the project because the payback period is over two and one-half years (or over 30 months).
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