Question

XYZ firm is a technology firm operating in a sector which is highly competitive and disruptive. The management has identified an investment in a new technology that will result in substantial savings. The investment in the new project is $ 10 million. The project delivers the cash flow starting year 1 as follows for the next 5 years: $ 1, 4, 6, 2, and 1 million. You are in the board meeting and want to understand the time taken for the deployed capital to come back to you. The firm is operating in a country that has traditionally high discount rates. The opportunity cost of capital for the investors in this firm is 15%.

a. Compute the payback period and the discounted payback period that you would communicate to the management.

b. Suppose, in a country with negative benchmark rates, a similar investment would have an opportunity cost of capital of 2%. Will there be any adjust-ments to the payback and discounted payback periods communicated to the management in such a scenario, why ?

Answer 1

For the purpose of discounted payback period, opportunity cost of capital is the discount rate applied.

Part (a):

Payback period (ordinary) = 2.83 years.

At the discount rate of 15%, discounted values of cash flow given for the 5 years will not be sufficient for the payback of investment, leaving a deficit of $0.52 Million. In other words, discounted payback period is higher than the project life of 5 years.

Details of calculation as follows:

Part (b):

Payback period (ordinary) = 2.83 years.

At the discount rate of 2%, discounted payback period = 2.92 years

Details of calculation as follows: