Question

Assume that the cost of an investment is $18,000. Because of the new machine; the after...

Assume that the cost of an investment is $18,000. Because of the new machine; the after tax cash savings to the firm is $3000 per year.

  • Determine the payback period.
  • Should the firm take on the investment?
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Answer #1

Payback period is the time required for the after tax cash flows to recover the initial investment.It can be calculated by the following formula:

Payback period = Net initial investment / Annual net after tax cash flow

Here, net initial investment = $18000, Annual net after tax cash flow = $3000

Payback period = $18000 / $3000 = 6 years

So, it will take 6 years for the firm to recover its amount invested. Payback period should be compared with the target payback period. If the payback period is less than or equal to target payback period, then the firm should take on the investment.

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