Question

5. The NPV and payback period

What information does the payback period provide?

Suppose you are evaluating a project with the expected future cash inflows shown in the following table. Your boss has asked you to calculate the project’s net present value (NPV). You don’t know the project’s initial cost, but you do know the project’s regular, or conventional, payback period is 2.50 years.

Year	Cash Flow
Year 1	$275,000
Year 2	$450,000
Year 3	$425,000
Year 4	$450,000

If the project’s weighted average cost of capital (WACC) is 8%, the project’s NPV (rounded to the nearest dollar) is:

$445,289

$371,074

$352,520

$296,859

Which of the following statements indicate a disadvantage of using the regular payback period (not the discounted payback period) for capital budgeting decisions? Check all that apply.

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

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

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

Answer 1

Initial investment= $275,000 + $450,000 + $425,000/2

= $275,000 + $450,000 + $212,500

= $937,500

Net present value can be solved using a financial calculator. The steps to solve on the financial calculator:

• Press the CF button.
• CF0= -$937,500. Indicate the initial cash flow by a negative sign since it is a cash outflow.  
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow cash flow, press the NPV button and enter the weighted average cost of capital of 8%.
• Press enter after that. Press the down arrow and CPT buttons to get the net present value.  

Net present value at 8% weighted average cost of capital is $371,074.24.

Hence, the answer is option b.

The disadvantage of regular payback period method is that it does not take the time value of money into account.

Hence, the answer is option a.

In case of any query, kindly comment on the solution.