Answer (C) is correct . The payback period is the number of years required to complete the return of the original investment. This measure is computed by dividing the net investment required by the average expected net cash inflow to be generated. The first step is to determine the annual cash flow. The $80,000 cost reduction will be offset by the tax expense on the savings. The full $80,000, however, will not be taxable because depreciation can be deducted before computing income taxes. Allocating the $250,000 cost evenly over 5 years produces an annual depreciation expense of $50,000. Thus, taxable income will be $30,000 ($80,000 – $50,000). At a 40% tax rate, the tax on $30,000 is $12,000. The net annual cash inflow is therefore $68,000 ($80,000 – $12,000), and the payback period is 3.68 years ($250,000 investment ÷ $68,000).
Answer (A) is incorrect because This figure does not take the increase in tax expense into account.
Answer (B) is incorrect because This figure deducts depreciation in the calculation of annual cash flows.
Answer (D) is incorrect because This figure does not include the effect of depreciation on taxable income.
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