Question

Builtrite has estimated their cost of capital is 14% and they are considering the purchase of a machine with the following capital budget:

Initial Investment	$62,000
RATFCF Year 1	$38,000
RATFCF Year 2	$30,000
RATFCF Year 3	$24,000

What is the machine’s payback period?     

		1.2 years
		2.21 years
		2.79 years
		1.8 years

Answer 1

Payback is the number of years taken by a project to re-earn invested amount.

Year 0 CF = - $62,000. Negative sign indicate it is a cash outflow

Year 1 CF = $38000. Cumulative cash flow = $38,000 + (-$62,000) = - $24,000

Year 2. CF = $30000. Cumulative cash flow = - $24,000 + 30,000) = $6,000

So the cumulative cash flow turns positive in year 2. This means payback is between year 1 and year 2. We need to compute the fraction between year 1 and year 2.

Fraction of year = 24,000/30,000 = 0.8 year

Payback = 1 + 0.8 year = 1.8 years