AP Shruti Shrills is considering an expansion of one of its existing buildings to add more manufacturing space for its kid-friendly noisemakers. Several possible scenarios exist for future cash flows, as follows. 1. Construction costs of $500,000; steady sales and costs each year, netting to an annual operating cash inflow of $70,000; the expansion would have no salvage value at the end of its 10-year useful life (the building would be repurposed for a different product). 2. Construction costs of $500,000; rising and then falling net cash flows each year for 10 years, as follows: $50,000 for the first 2 and last 2 years, $175,000 for years 3–5, and $100,000 for years 6–8. 3. Construction costs of $700,000; no cash flows in year 1, $75,000 in years 2 and 3, $150,000 in year 4, $100,000 in years 5–8, and $50,000 in the last 2 years. Required 1. Calculate the simple payback period for all three scenarios. 2. Assume that Shruti will only accept investments with a payback period of 5 years or less. Would any of these scenarios hold the interest of the company? Why might the company follow such a strict standard for this metric? 3. What are the total cash flows that each scenario will generate over the 10-year life of this project? Is that amount taken into consideration when determining the payback period?
E7.7 (LO 3, 4), AP Shruti Shrills is considering an expansion of one of its existing buildings to add more manufacturing space for its kid-friendly noisemakers. Several possible scenarios exist for future cash flows, as follows.
1. Construction costs of $500,000; steady sales and costs each year, netting to an annual operating
2. Construction costs of $500,000; rising and then falling net cash flows each year for 10 years, as follows: $50,000 for the first 2 and last 2 years, $175,000 for years 3–5, and $100,000 for years 6–8.
3. Construction costs of $700,000; no cash flows in year 1, $75,000 in years 2 and 3, $150,000 in year 4, $100,000 in years 5–8, and $50,000 in the last 2 years.
Required
1. Calculate the simple payback period for all three scenarios.
2. Assume that Shruti will only accept investments with a payback period of 5 years or less. Would any of these scenarios hold the interest of the company? Why might the company follow such a strict standard for this metric?
3. What are the total cash flows that each scenario will generate over the 10-year life of this project? Is that amount taken into consideration when determining the payback period?
4. Does the simple payback period calculation consider the present value of any cash flows? What are the advantages/disadvantages of using this payback period metric for investment decisions?
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