Consider the following four-year project. The initial after-tax outlay or after-tax cost is $1,000,000. The future after-tax cash inflows for years 1, 2, 3 and 4 are: $400,000, $300,000, $200,000 and $200,000, respectively
What is the payback period without discounting cash flows?
A) 2.5 years
B) 3.0 years
C) 3.5 years
D) 4.0 years
Answer: C
Explanation: C) We can see that after three years, we will have paid back $900,000. Thus, we only need $100,000 in after-tax cash flows in the 4th year. Because we get $200,000 in the fourth year, the rule of thumb is to divide what is needed by the cash inflows we will get next period and add the results to the number of previous periods of cash inflows, e.g., ($100,000 divided by $200,000) + 3 which gives 3.500. Thus, the payback period is 3.5 years.
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