Question

Bellinger Industries is considering two projects for inclusion in its capital budget, and you have been asked to do the analysis. Both projects' after-tax cash flows are shown on the time line below. Depreciation, salvage values, net operating working capital requirements, and tax effects are all included in these cash flows. Both projects have 4-year lives, and they have risk characteristics similar to the firm's average project. Bellinger's WACC is 8%.

0 1 2 3 4 5
Project A -1,050 700 420 240 290
Project B -1,050 300 355 390 740
What is Project A's payback? Round your answer to four decimal places. Do not round your intermediate calculations.

Answer 1

Project A's payback period is calculated by determining when the cumulative cash flows exceed the initial investment of $1,050. By the end of Year 2, the cumulative cash flow does so, and the exact payback period is 1.8333 years when rounded to four decimal places.

Step-by-step explanation:

To determine Project A's payback period, we need to find out how long it will take for the project's cumulative cash flows to cover the initial investment of $1,050. The cash flows for Project A over its 4-year life are as follows:

• Year 1: $700
• Year 2: $420
• Year 3: $240
• Year 4: $290

We calculate the cumulative cash flow at the end of each year:

1. End of Year 1: $700
2. End of Year 2: $700 + $420 = $1,120

By the end of Year 2, the cumulative cash flow of $1,120 exceeds the initial investment of $1,050. Therefore, the payback period for Project A is sometime during Year 2. To find the exact point, we calculate the remaining amount to be recovered at the start of Year 2, which is $1,050 - $700 = $350, and then divide this by the Year 2 cash flow:

$350 / $420 = 0.8333

Thus, Project A's payback period is 1 year plus the portion of the second year, which equals to 1.8333 years. When rounded to four decimal places, it is 1.8333.