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Sir please help me with the following question:
A company is considering an investment of $400000 in new machinery. The machinery is expected to yield incremental profits over the next five years as follows:
Year Profits($)
1 175000
2 225000
3 340000
4 165000
5 125000Thereafter, no incremental profits are expected and the machinery will be sold. It is company policy to depreciate machinery on a straight line basis over the life of the asset. The machinery is expected to have a value of $50000 at the end of year 5.
Calculate the payback period of the investment in this machinery to the nearest 0.1 years.
A. 0.9 years
B. 1.3 years
C. 1.5 years
D. 1.9 years.I assume that you have watched my lecture, and therefore you know that the payback period is the number of years it takes in cash terms to get back the initial investment.
The profits are not the cash flows, so first you need to add back the depreciation.
The depreciation is (400000 – 50000) / 5 = 70,000 per year.So the cash flows are
1 245000
2 295000and so on.
We need to get back an investment of 400000.
After 1 year we have got back 245000, which means we need another 400000 – 245000 = 155000.
This will take the following fraction of the second year: 155000/295000 = 0.5So the answer is C
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