Acme, Inc. is considering a four-year project that has initial outlay

Acme, Inc. is considering a four-year project that has initial outlay or cost of $100,000. The respective cash inflows for years 1, 2, 3 and 4 are: $50,000, $40,000, $30,000 and $20,000.

Acme uses the discounted payback period method, and has a discount rate of 11.50%. Will Acme accept the project if it’s payback period is 37 months?
A) Yes, because it pays back in less than 37 months.
B) No, because it pays back in over 37 months.
C) No, because it pays back in over 38 months.
D) No, because it pays back in over 40 months.

ANSWER

Answer: B
Explanation: B) We first discount all after-tax cash inflows, which gives us after-tax cash inflows of $44,843.05, $32,174.39, $21,641.96, and $12,939.89. After three years or 36 months, we will have paid back $98,659.40, leaving $1,340.60 to pay back in after-tax cash flows in the fourth year. Since we get $12,939.89 in the fourth 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., ($1,340.60 divided by $12,939.89) + 3. Doing this gives 3.104. Thus, the payback period in months is 3.104 × 12 = 37.243 months. Because this is over 37 months, Acme does not accept the project.