Question

You are evaluating a project that will cost $ 527,000​, but is expected to produce cash flows of $ 125 comma 000 per year for 10 ​years, with the first cash flow in one year. Your cost of capital is 11 % and your​ company's preferred payback period is three years or less.

a. What is the payback period of this​ project?
b. Should you take the project if you want to increase the value of the​ company?

Answer 1

(a)-Project’s Payback Period

- The Payback Period Method refers to the period in which the proposed project will generate the cash inflows to recover the Initial Investment costs. It considers only three components such as Initial Investment costs, Economic life of the project and the annual cash inflows

- Payback period is the number of years taken to recover the total amount of money invested in the project. If the payback period is less than the enterprises required number of years, then the project should be accepted, Else it is rejected.

-The Payback Period = Initial Investment / Annual cash inflow

The Payback Period for the Project is calculated by using the following formula

Project’s Payback Period = Initial Investment Cost / Annual Cash Inflow

= $527,000 / $125,000 per year

= 4.22 Years

“Hence, the Payback Period for the Project will be 4.22 Years”

(b)-DECISION

-Using the payback decision rule, the Project should be accepted only if the Payback Period for the Project is less than the company's preferred payback period

-Here, the Payback Period for the Project (4.22 Years) is higher than the company's preferred payback period (3.00 Years or more), therefore, the firm should reject the Project.