Question

why do they sum net cash flows instead of net income?

An anticipated purchase of equipment for $490,000 with a useful life of 8 years and no residual value is expected to yield the following annual net incomes and net cash flows:

Year	Net Income		Net Cash Flow
1	$60,000		$110,000
2	50,000		100,000
3	50,000		100,000
4	40,000		90,000
5	40,000		90,000
6	40,000		90,000
7	40,000		90,000
8	40,000		90,000

What is the cash payback period?

a.5 years

b.4 years

c.3 years

d.6 years

Answer 1

Payback period for uneven cash flows is calculated by the following formula

Payback Period =	A +	B
		C

Where,
A is the last period number with a negative cumulative cash flow;
B is the absolute value (i.e. value without negative sign) of cumulative net cash flow at the end of the period A; and
C is the total cash inflow during the period following period A

The following table shows the calculations :

Year	Cash Flows	Cumulative Cash Flows
0	-490000	-490000
1	110000	-380000
2	100000	-280000
3	100000	-180000
4	90000	-90000
5	90000	0
6	90000	90000
7	90000	180000
8	90000	270000

So, as per above equation, Payback period

= 4 + |-90,000 | / 90,000

= 4 + 1

= 5 Years

So, as per above calculations, option a is the correct option