Question

7. The NPV and payback period

What information does the payback period provide?

Suppose Omni Consumer Products’s CFO is evaluating a project with the following cash inflows. She does not know the project’s initial cost; however, she does know that the project’s regular payback period is 2.5 years.

Year	Cash Flow
Year 1	$275,000
Year 2	$450,000
Year 3	$475,000
Year 4	$400,000

If the project’s weighted average cost of capital (WACC) is 8%, what is its NPV?

$331,563

$349,014

$401,366

$279,211

Which of the following statements indicate a disadvantage of using the discounted payback period for capital budgeting decisions? Check all that apply.

The discounted payback period does not take the project’s entire life into account.

The discounted payback period is calculated using net income instead of cash flows.

The discounted payback period does not take the time value of money into account.

Answer 1

1. What information does the payback period provide?

Answer: Payback period refers to the time period in terms of years or months within which an entity will recover its investment made at the initial point of time. In other words, through such analysis an entity could know that within how much time an entity could recover it's investment.

2. Suppose Omni Consumer Products’s CFO is evaluating a project with the following cash inflows. She does not know the project’s initial cost; however, she does know that the project’s regular payback period is 2.5 years.

Answer: If the person does not know the initial cost of the project but knows that payback period is 2.5 years then initial cost could be computed through such analysis.

Cost of Project= Cash Flow at year 1 + Cash Flow at year 2 + (0.50)*Cash Flow at year 3 (Note: Half has been taken as to account the 0.5 of cash flow in year 3.

= $275000+$450000+ (0.50*$475000)

=$962,500

Thus the initial cost has been computed above as $962,500.

3. Following is the formula table for computation of NPV:

Following is the computation of NPV:

Thus the correct option is (b) which is $349,014.35.

4. Which of the following statements indicate a disadvantage of using the discounted payback period for capital budgeting decisions? Check all that apply.

The correct option is (a) which is states that it does not take into account the entire life of the project. It is the only disadvantage of the method as it only computes the horizon within which an entity will recover its investment and completely ignores rest of life of project.

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