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Mistral Manufacturing is considering an investment in a new, high-efficiency machine. The new machine requires an initial investment of $1,750,000 and generates cash flows of either of the following: Even cash flows of $350,000 per year or The following expected annual cash flows from Year 1 through Year 5: $275,000, $420,000, $820,000, $470,000, and $150,000
Required: Calculate the payback period for each case.

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Answer:

Case 1 = 5 years

Case 2 = 3.5 years

Explanation:

We calculate the payback as follows,

Case 1

Initial Outlay = $1,750,000

Even cash flow = $350,000

Payback = 1,750,000 / 350,000 = 5 years

Case 2

Initial Outlay = $1,750,000

we subtract each cash flow from the outlay until we get 0.

Payback

= 1750000 - 275,000 = $1,475,000    = + 1 year

= 1475000 - 420000 = $1,055,000    = + 1 year

= 1055000 - 820000 = $235,000      = + 1 year

Since next year we have cash flows of $470,000 we see the cover for remaining outlay of $235,000 by,

235,000/470000 = + 0.5 year

we compute total years by adding

Payback = 1 + 1 + 1 + 0.5 = 3.5 years

Hope that helps.

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