Evaristo Corporation is considering an investment in equipment for $45,000. Data related to the investment are as follows: $$\begin{array}{l}\begin{array} { c c }
&\text { Cash Flow before }\

\text { Year } & \text { Depreciation and Taxes } \
\hline 1 & \$ 30,000 \
2 & 30,000 \
3 & 30,000 \
4 & 30,000 \
5 & 30,000
\end{array}
\end{array}$$ Cost of capital is 18 percent. Evaristo uses the straight-line method of depreciation with no mid-year convention. In addition, its tax rate is 40 percent, and the life of the equipment is five years with no salvage value. What is the payback period in years approximated to two decimal points?

Question

Evaristo Corporation is considering an investment in equipment for $45,000. Data related to the investment are as follows: $$\begin{array}{l}\begin{array} { c c } 
&\text { Cash Flow before }\

\text { Year } & \text { Depreciation and Taxes } \
\hline 1 & \$ 30,000 \
2 & 30,000 \
3 & 30,000 \
4 & 30,000 \
5 & 30,000
\end{array}
\end{array}$$ Cost of capital is 18 percent. Evaristo uses the straight-line method of depreciation with no mid-year convention. In addition, its tax rate is 40 percent, and the life of the equipment is five years with no salvage value. What is the payback period in years approximated to two decimal points?

Quizplus · Accepted Answer

The payback period is calculated by determining how long it takes for the initial investment to be recovered through the net cash flows. Here, the net cash flow needs to be adjusted for taxes and depreciation. The initial investment is $45,000. Depreciation per year is $45,000 / 5 = $9,000. The cash flow before depreciation and taxes is $30,000 annually. After accounting for depreciation, the taxable income is $30,000 - $9,000 = $21,000. Taxes on this are 40% of $21,000 = $8,400. Thus, the net cash flow after taxes is $30,000 - $8,400 = $21,600 annually. To recover the initial investment of $45,000 at a net cash flow of $21,600 per year, it takes $45,000 / $21,600 ≈ 2.08 years.

Evaristo Corporation Is Considering an Investment in Equipment for $45,000