Jelly Company is considering purchasing a machine with a cost of $20,000 and a useful life of 10 years. Jelly expects the machine to produce net annual cash flows of $2,000 in year 1, $10,000 in year 2, $5,000 in year 3, $12,000 in year 4, and $8,000 in year 5. What is the cash payback period of the machine?

 Jelly Company is considering purchasing a machine with a cost of $20,000 and a useful life of 10 years. Jelly expects the machine to produce net annual cash flows of $2,000 in year 1, $10,000 in year 2, $5,000 in year 3, $12,000 in year 4, and $8,000 in year 5. What is the cash payback period of the machine?

multiple choice
3 years
3.5 years
3.25 years Correct
4.25 years

Explanation
Knowledge Check 01
 
At the end of Year 0, the cumulative cash flows = Cost of $(20,000). At the end of Year 1, the cumulative present value of the cash flows = Year 0 amount of $(20,000) + Year 1 cash flow of $2,000 = $(18,000). At the end of Year 2, the cumulative cash flows = Year 1 amount of $(18,000) + Year 2 cash flow of $10,000 = $(8,000). At the end of Year 3, the cumulative cash flows = Year 2 amount of $(8,000) + Year 3 cash flow of $5,000 = $(3,000). At the end of Year 4, the cumulative cash flows = Year 3 amount of $(3,000) + Year 4 cash flow of $12,000 = $9,000. The cash flows changes from a negative to a positive number between years 3 and 4. If we assume that cash flows are received uniformly within each year, receipt of the $3,000 (to cover Year 3’s cumulative negative cash flow), occurs about 25% (or $3,000 ÷ Year 4’s cash flow of $12,000) the way through year 4. Thus, the payback period = 3.25 years (or 3 years + 0.25 years).

 

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