An investment that costs $120,000 is estimated to reduce cash operating costs by $40,000 per year for 4 years.The required rate of return is 10 percent.Determine the payback period assuming an inflation rate of 8 percent on the operating costs saved.

Question

Quizplus · Accepted Answer

The payback period is calculated by dividing the initial investment by the annual cash inflow. However, with an 8% inflation rate affecting the operating costs saved, the real value of the annual savings decreases over time. The first year's savings are $40,000. For subsequent years, the savings need to be adjusted for inflation: Year 2: $40,000 / (1 + 0.08) = $37,037.04, Year 3: $40,000 / (1 + 0.08)^2 = $34,251.85, Year 4: $40,000 / (1 + 0.08)^3 = $31,713.01. Adding these up until the total reaches $120,000 gives a payback period of about 2.79 years, considering the diminishing value of the savings due to inflation.

An Investment That Costs $120,000 Is Estimated to Reduce Cash