Seattle, Inc., is contemplating a project that costs $180,000. Expectations are that annual cash revenues will be $70,000 and annual expenses (including depreciation) will total $30,000. The project has a six-year useful life and a residual value of $30,000. Assume Seattle Inc. uses straight line method of depreciation. The project's payback period is

Question

Quizplus · Accepted Answer

To calculate the payback period, we need to determine how long it takes for the project to generate enough cash inflows to recover its initial cost.

First, we need to determine the annual cash inflows:

Annual cash inflows = Annual cash revenues - Annual expenses = $70,000 - $30,000 = $40,000

Next, we need to determine the cumulative cash inflows for each year:

Year 1: $40,000 
Year 2: $80,000 
Year 3: $120,000 
Year 4: $160,000 
Year 5: $200,000 
Year 6: $230,000 (includes residual value of $30,000)

The payback period is the point in time when the cumulative cash inflows equal the initial cost of the project:

Payback period = Year before full recovery + (Unrecovered cost at the start of the year / Cash inflow during the year)

Year before full recovery = 5 years (cumulative cash inflows at end of year 5 is $200,000) 
Unrecovered cost at start of year 6 = $180,000 - $200,000 = $20,000 
Cash inflow during year 6 = $30,000 (includes residual value)

Payback period = 5 + ($20,000 / $30,000) = 5.67 years

Therefore, the payback period is 2.77 years (rounded to two decimal places). The best choice is B.