Question

What information does the payback period provide?

Suppose Praxis Corporation’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	$350,000
Year 2	$450,000
Year 3	$500,000
Year 4	$425,000

If the project’s weighted average cost of capital (WACC) is 10%, what is its NPV?

$321,322

$306,021

$290,720

$275,419

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 time value of money into account.

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

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

Answer 1

a) In simple terms, payback period is the time taken to recover the initial cost of the investment and does not consider time value of money

b) Using the Financial calculator, we will compute the NPV

First, we need to compute the Initial investment

Payback period = 2.5 years

So total investment will be cash flows first two years and half amount of the third year

= $350,000+$450,000+$500,000/2

= $1,050,000

Now,we will compute the NPV

CFo = -$1,050,000

CF1 = $350,000, CF2 = $450,000 , CF3 = $500,000 and CF4 = $425,000

Discount rate = 10%

NPV = $306,021

Option B

C) Option 3 - The discounted payback period does not take the project’s entire life into account.

Explanation: Discounted payback period considers the time value of money and incorporate the cash flows but disadvantage is that it does not consider the entire life of the project

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