Floyd Clymer is the CFO of Bonavista Mustang, a manufacturer of parts for classic automobiles. Floyd is considering the purchase of a two-ton press which will allow the firm to stamp out auto fenders. The equipment costs $250,000. The project is expected to produce after-tax cash flows of $60,000 the first year, and increase by $10,000 annually; the after-tax cash flow in year 5 will reach $100,000. Liquidation of the equipment will net the firm $10,000 in cash at the end of five years, making the total cash flow in year five $110,000. What is the payback period for the proposed investment?

Question

Quizplus · Accepted Answer

The payback period is calculated by adding the annual cash flows until the initial investment is recovered. Year 1: $60,000, Year 2: $70,000 (increases by $10,000), Year 3: $80,000, Year 4: $90,000, and Year 5: $100,000 (ignoring the liquidation value for now as it's about reaching the initial investment). By the end of Year 4, the total cash flow is $300,000 ($60,000 + $70,000 + $80,000 + $90,000), which covers the initial investment of $250,000. To find the exact payback period, we see that by the end of Year 3, the total cash flow is $210,000, which is $40,000 short of the initial investment. The cash flow in Year 4 is $90,000. The payback period is 3 years plus the portion of the fourth year needed to cover the remaining $40,000. Since $40,000 is 44.44% of the Year 4 cash flow ($90,000), the payback period is approximately 3.4 years.

Floyd Clymer Is the CFO of Bonavista Mustang, a Manufacturer