Question

Which of the following statements is (are) correct? (x) If the cost of an investment is $20,000 and the annual sales from the investment is 12.5 percent of the cost, then the payback period is 8.0 years.
(y) It is always possible to determine a payback period when the cash inflows from the project are uneven as long as the cash inflows exceed the cost of the project.
(z) If the discounted payback period for a given project is longer than the payback benchmark then the firm will not pursue the project even though it may have a NPV greater than zero.
A. (x), (y) and (z)
B. (x) and (y) only
C. (x) and (z) only
D. (y) and (z) only
E. (z) only

You are considering the purchase of an investment that would pay you $2,450 per year for Years 1, 2 and 3, $2,225 per year for Years 4, 5, 6 and 7, and $1,850 per year for Years 8, 9 and 10. If you require a 11.25% rate of return, and the cash flows occur at the end of each year, then how much should you be willing to pay for this investment?
A. more than $14,550
B. between $14,100 and $14,550
C. between $13,650 and $14,100
D. between $13,200 and $13,650
E. between $12,750 and $13,200

As a student of finance, you predict that the net present value (NPV) of a proposed new $12.5 million warehouse is $1 million. You determined that the firm’s cost of capital is 8.75%. How should these findings be interpreted?
A. More information such as the payback period should be evaluated since the reliance on only one capital budgeting technique should be discouraged.
B. Although NPV is positive, its value is too low for such a large expenditure and as a result, the project should be rejected.
C. The project should be rejected because the NPV is less than the 8.75% of the cost of the warehouse.
D. The project does not meet the acceptance criteria of the NPV method and should be rejected.
E. The project should be accepted because it will add value to the firm.

Answer 1

1. B. Only x and y (if revenue 12.5% of the cost, then payback period=1/12.5%=8. And even if cash flow is uneven, payback period can be determined, if NPV is zero then project can be accepted)

2.

Below is the calculation of the present value for such cash flow:

Year	Cashflow	Present Value @11.25% (i.e. Cashflow/1.1125^year)
1	2,450.00	2,202.25
2	2,450.00	1,979.55
3	2,450.00	1,779.37
4	2,225.00	1,452.55
5	2,225.00	1,305.66
6	2,225.00	1,173.63
7	2,225.00	1,054.95
8	1,850.00	788.45
9	1,850.00	708.71
10	1,850.00	637.05
	Total	13,082.15

So, you need to invest $13082.15. Option E is correct.

3. E. The project should be accepted as the project will add value to the firm.