A company is considering purchasing factory equipment that costs $320,000 and is estimated to have no salvage value at the end of its 8-year useful life. If the equipment is purchased, annual revenues are expected to be $90,000 and annual operating expenses exclusive of depreciation expense are expected to be $38,000. The straight-line method of depreciation would be used.
The cash payback period on the equipment is
A) 13.3 years.
B) 8.0 years.
C) 6.2 years.
D) 3.1 years.

Question

Quizplus · Accepted Answer

To calculate the cash payback period, we need to determine how many years it will take for the annual net cash inflows to equal the initial investment.

Annual net cash inflow = Annual revenues – Annual operating expenses exclusive of depreciation expense 
= $90,000 - $38,000 
= $52,000

Annual depreciation expense = Cost of equipment / Useful life = $320,000 / 8 = $40,000

Annual net cash flow = Annual net cash inflows – Annual depreciation expense = $52,000 - $40,000 = $12,000

Cash payback period = Initial investment / Annual net cash flow = $320,000 / $12,000 = 26.67 years

The cash payback period is longer than the useful life of the equipment, so it is not a good investment.

However, we can also calculate the cumulative net cash flow for each year:

Year 1: $52,000 - $40,000 = $12,000 
Year 2: $52,000 - $40,000 = $12,000 + $12,000 = $24,000 
Year 3: $52,000 - $40,000 = $12,000 + $12,000 + $12,000 = $36,000 
Year 4: $52,000 - $40,000 = $12,000 + $12,000 + $12,000 + $12,000 = $48,000 
Year 5: $52,000 - $40,000 = $12,000 + $12,000 + $12,000 + $12,000 + $12,000 = $60,000 
Year 6: $52,000 - $40,000 = $12,000 + $12,000 + $12,000 + $12,000 + $12,000 + $12,000 = $72,000

By the end of year 6, the cumulative net cash flow exceeds the initial investment of $320,000. Therefore, the cash payback period is 6.2 years (between years 5 and 6).

Option C is the correct answer.

A Company Is Considering Purchasing Factory Equipment That Costs $320,000