Exercise 24-5 Payback period computation; even cash flows LO P1 Compute the payback period for each of these two separate investments: A new operating system for an existing machine is expected to cost $520,000 and have a useful life of six years. The system yields an incremental after-tax income of $150,000 each year after deducting its straight-line depreciation. The predicted salvage value of the system is $10,000. A machine costs $380,000, has a $20,000 salvage value, is expected to last eight years, and will generate an after-tax income of $60,000 per year after straight-line depreciation.

Answer and Explanation:

The computation of the payback period is shown below:

1. Payback period = Initial investment : Net cash flow

where,

Initial investment is $520,000

Net cash flow is = incremental after-tax income + depreciation expense

= $150,000 + $85,000

= $235,000

The depreciation expense is

= ($520,000 - $10,000) : (6 years)

= $85,000

Now the payback period is

= $520,000 : $235,000

= 2.21 years

2. Payback period = Initial investment : Net cash flow

where,

Initial investment is $380,000

Net cash flow is = incremental after-tax income + depreciation expense

= $60,000 + $45,000

= $105,000

The depreciation expense is

= ($380,000 - $20,000) : (8 years)

= $45,000

Now the payback period is

= $380,000 : $105,000

= 3.62 years