Vandezande Inc. is considering the acquisition of a new machine that costs $438,000 and has a useful life of 5 years with no salvage value The incremental net operating income and incremental net cash flows that would be produced by the machine are (ignore income taxes) Incremental Incremental Net Operating Net Cash Income s 79, 000 $ 85,000 Year 3 96,000 Year 4 59,000 Year S $101,000 Flows Year 1 Year 2 $154, 000 $164,000 $175, 000 $161,000 $163,000 Assume cash flows occur uniformly throughout a year except for the initial investment The payback period of this investment is closest to: a) 22 years b) 5.0 years c) 4.3 years d) 2.7 years

Vandezande Inc.

The payback period of this investment is closest to:

d) 2.7 years

Explanation:

a) Data and Calculations:

Incremental Net Operating Incomes   Net Cash  Flows  Incremental cash

Year 1              $79, 000                           $154, 000      

Year 2            $ 85,000                             $164,000             $318,000

Year 3               96,000                            $175, 000               493,000

Year 4              59,000                              $161,000               654,000

Year 5           $101,000                              $163,000               817,000

Total            $420,000                              $817,000

Payback period = Cash outflow/ (Total cash inflows/5)

= $438,000/($817,000/5)

= $438,000/$163,400

= 2.68

= 2.7 years

b) Payback period is the time an investment takes to recover its initial cost, at which the break-even point is reached.  Shorter payback period increases the attractiveness and desirability of an investment.  Another method to calculate the payback period is the subtraction method.  This involves subtracting the cash inflows from the cash outflow until the cash outflow becomes zero.