Question

5. The NPV and payback period

Part A

What information does the payback period provide?

Suppose Acme Manufacturing corp CFO is evaluating a project w the following cash Inflows. She does not know the project's initial cost; however he does know that the projects regular payback period is 2.5 years.

Year Cash flow

1. $350,000

2. $400,000

3. $400,000

4. $400,000

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

answer options: $326,990; $299,741; $231,618; $272,492

Part B

Which of the following statements indicate a disadvantage of using the discounted payback period for capital budgeting decisions? Check all that apply

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

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

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

Answer 1

Part-A

- Payback Period = Years before the Payback period occurs + (Cummulative cash flow in the year before recovery/Csh flow in the year before recovery)

Let the Initial Investment be X.

2.5 = 2years + [(X-$350,000-$400,000)/$400,000]

0.5 = [(X-$350,000-$400,000)/$400,000]

200,000 = X-$750,000

X = $ 950,000

So, now we know the Initial Investment. Calculating the NPV of the project:-

Year	Cash Flows of ($)	PV Factor @10%	Present Value of ($)
0	(950,000.00)	1.0000	(950,000.00)
1	350,000.00	0.9091	318,181.82
2	400,000.00	0.8264	330,578.51
3	400,000.00	0.7513	300,525.92
4	400,000.00	0.6830	273,205.38
		NPV	272,491.63

So, NPV of the Project is $272,491.63

Hence, Option D

Part-B

Ans- Option 2. The discounted payback period does not take the project's entire life into account.

While evaluating the Capital bugeting decisions, Discount payback period only considers the Discounted cash flows that are able to recover the initial investment costs and ignores the future periodic discounted cash flows. THus, it fairly ignores the discounted cash flows of the entire life of project which is beneficial to obtain the required return from the capital budgeting.

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