Question

11. The NPV and payback period What information does the payback period provide? Payback period essentially provides the number of years it would take for a project to recover the initial investment from its operating cash flows. As the model was criticized, the model evolved incorporating time value of money to create the discounted payback method. The models still reflected faulty ranking criteria but they provided important information about liquidity and risk. The ______(shorter or longer)____ the payback, other things constant, the greater the project’s liquidity. 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 $375,000 Year 2 500,000 Year 3 475,000 Year 4 500,000 If the project’s weighted average cost of capital (WACC) is 8%, what is its NPV? $489,572 $367,179 $469,174 $407,977 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

The shorter the payback, other things constant, the greater the project’s liquidity.

NPV is computed as follows:

Payback period is 2.5 years which means it has taken 2.5 years in order to recover our initial outflow.

So the initial outflow will be computed as shown below:

= Year 1 cash inflow + Year 2 cash inflow + 0.50 x Year 3 cash inflow

= $ 375,000 + $ 500,000 + 0.50 x $ 475,000

= $ 1,112,500

So now we shall compute the NPV at 8% as follows:

= - $ 1,112,500 + $ 375,000 / 1.08¹ + $ 500,000 / 1.08² + $ 475,000 / 1.08³ + $ 500,000 / 1.08⁴

= $ 407,977 Approximately

So the correct answer is option of $ 407,977

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

So the correct answer is option of The discounted payback period does not take the project’s entire life into account.

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