Jamaica Corp. is adding a new assembly line at a cost of $8.5 million. The firm expects the project to generate cash flows of $2 million, $3 million, $4 million, and $5 million over the next four years. Its cost of capital is 16 percent. What is the payback period for this project? (Round your answer to one decimal place.)
A) 2.7 years
B) 2.9 years
C) 3.1 years
D) 3.4 years

Question

Quizplus · Accepted Answer

To calculate the payback period, we need to determine in which year the project will recoup the initial investment. First, we calculate the cumulative cash flows:
Year 1: $2 million
Year 2: $2 million + $3 million = $5 million
Year 3: $5 million + $4 million = $9 million
Year 4: $9 million + $5 million = $14 million

The payback period is the point at which the cumulative cash flows equal the initial investment of $8.5 million. This occurs in Year 2, when cumulative cash flows reach $5 million. So the payback period is 2 years plus:

($8.5 million – $5 million in Year 2) ÷ $4 million in Year 3 = 0.875 years

Therefore, the payback period is 2.9 years. Since this is less than the industry average of 3 years, the project should be accepted.