Question

Hodgman Honest is evaluating a new project for her firm, Basket Wonders (BW). She has determined that the after-tax cash flows for the project will be $10,000; $12,000; $15,000; $10,000; and $7,000, respectively, for each of the Years I through 5. The initial cash outlay will be $40.000. For this project, assume that it is independent of any other potential projects that Basket Wonders may undertake. The management of Basket Wonders has set a maximum PBP of 3.5 years for projects of this type. Required: Evaluate this project using payback period technique and advise the management accordingly.​

Answer 1

To calculate the payback period (PBP) for this project, we need to determine how long it will take for the initial cash outlay of $40,000 to be recovered from the after-tax cash flows.

Year 1 cash flow = $10,000

Year 2 cash flow = $12,000

Year 3 cash flow = $15,000

Year 4 cash flow = $10,000

Year 5 cash flow = $7,000

Total cash inflows for year 1 and year 2 = $10,000 + $12,000 = $22,000

Total cash inflows for year 3 = $15,000

Total cash inflows for year 4 = $10,000

Total cash inflows for year 5 = $7,000

Cumulative cash inflows for year 1 and year 2 = $22,000

Cumulative cash inflows for year 3 = $37,000

Cumulative cash inflows for year 4 = $47,000

Cumulative cash inflows for year 5 = $54,000

It can be seen that the cumulative cash inflows reach the initial cash outlay of $40,000 after year 2, and therefore the payback period for this project is 2 years. Since the payback period is less than the maximum PBP of 3.5 years set by management, this project can be considered acceptable.

So, Hodgman Honest should recommend that Basket Wonders should accept this project as it has a payback period of only 2 years, which is less than the maximum PBP of 3.5 years set by management.