Floyd Clymer is the CFO of Bonavista Mustang, a manufacturer of parts for classic automobiles. Floyd is considering the purchase of a two-ton press which will allow the firm to stamp out auto fenders. The equipment costs $250,000. The project is expected to produce after-tax cash flows of $60,000 the first year, and increase by $10,000 annually; the after-tax cash flow in year 5 will reach $100,000. Liquidation of the equipment will net the firm $10,000 in cash at the end of five years, making the total cash flow in year five $110,000. Assume the required return is 15%. What is the project's discounted payback period?

A) two years
B) three years
C) four years
D) five years
E) Longer than the project's life.

Question

Katherine Lindahl · Accepted Answer

Final Answer : D, Explanation :  The discounted payback period is the time it takes for the discounted cash flows to pay back the initial investment. To find this, we discount each of the cash flows back to their present value using the required return rate of 15%. Year 1: $60,000 / (1 + 0.15)^1 = $52,173.91Year 2: $70,000 / (1 + 0.15)^2 = $52,710.90Year 3: $80,000 / (1 + 0.15)^3 = $52,644.04Year 4: $90,000 / (1 + 0.15)^4 = $52,020.24Year 5: $110,000 / (1 + 0.15)^5 = $52,593.99Adding these up: $52,173.91 + $52,710.90 + $52,644.04 + $52,020.24 + $52,593.99 = $262,143.08The initial investment is $250,000, and by adding the discounted cash flows, we see that the investment is paid back between the fourth and fifth year, but not before the end of the fourth year. Therefore, the discounted payback period is during the fifth year.

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