Intelligent Semiconductor is considering the development of a new data storage medium, which will allow tremendous increases in the efficiency of its customer's high-end server lines. The development of the new system will take place in Intelligent's existing facilities, and the storage costs for the additional equipment are expected to be residual in nature. The following information applies to this project:
Rent expense for existing facilities ($10,500)
Initial cash outlay ($50,000)
t1: $15,000
t2: $11,000
t3: $11,000
t4: $15,000
t5 $25,000
Discount rate: 9%
Assuming no taxes or related charges, that the initial cash outlay does not include any sunk costs, and a $0.00 salvage value at after the fifth year, which of the following choices best represents the payback period for this investment?
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A. B. C. D. E.Explanation
Remember that the rental expense of the firm's existing facilities is a sunk cost, and should not be incorporated into the calculation. This is due to the fact that the rental expense is not incremental in nature, and is unaffected by the acceptance of the project in question. In this example, the payback period is approximately
3.87 years. After the third year, $37,000 of the initial $50,000 investment has been recouped, leaving $13,000 to be recovered. The following period has a cash inflow of $15,000, exceeding the $13,000 amount required to completely "pay back" the initial investment. To calculate the period required, divide the $13,000 left to be recouped by the $15,000 cash inflow during period 4. This will yield an answer of 0.8667, which is added to the three-year period already passed, giving an answer of 3.87 years. While somewhat appealing in a simplistic sense, the payback period is not an advisable method for valuation and analysis of capital projects, primarily due to the fact that this method completely ignores the time value of money principle which governs the field of finance.