Question

Ashley Ardern has been researching a vaccine for Covid-19. The cost of the research efforts has already amounted to $500,000. If Ashley Ardern carries on the research efforts additional lab space and equipment will need to be purchased for $1,000,000 to ensure adequate social distancing is maintained. At the end of a 2 year period, it is estimated that the salvage value of the equipment will be $0. The results of the research are expected to result in a vaccine that will generate positive cash flows for two years. The estimated after-tax operating cash inflows are $572,000 in year 1 and $744,000 in year 2. The operating cash flows are earned evenly throughout the year. Additional working capital of $100,000 will be required at the start of the project. The company has an after-tax required rate of return of 10% per annum. Question: The payback period (to the nearest month) is:

(a) 1 year, 9 months

(b) 1 year, 7 months

(c) 2 years, 0 months

(d) It does not payback

Answer #1

a.1 year, 9 months.

total cash outflow to be recovered = $1,000,000 purchase price + $100,000 additional working capital

=>$1,100,000.

year | cash flow | cumulative cash flow |

1 | 572,000 | 572,000 |

2 | 744,000 | 572,000+744,000 =>1,316,000 |

since the amount is recovered in second year, the payback period lies between year 1 and year 2.

exact payback period = 1 year + (total cash flow required- cumultive cash flow / second year cash flow)*12 months

=>1 year + (1,100,000 - 572,000) / 744,000*12 months

=>1 year + 0.7097 *12

=>1.year + 8.5 months.

=>1 year 9 months.

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