Question

V & T Faces, Inc., would like to open a retail store in Miami. The initial investment to purchase the building is $420,000, and an additional $50,000 in working capital is required. Since this store will be operating for many years, the working capital will not be returned in the near future. V & T Faces expects to remodel the store at the end of 3 years at a cost of $100,000. Annual net cash receipts from daily operations (cash receipts minus cash payments) are expected to be as follows:

Year 1 $80,000

Year 2 $115,000

Year 3 $118,000

Year 4 $140,000

Year 5 $155,000

Year 6 $167,000

Year 7 $175,000

The company’s required rate of return is 13 percent.

Assume management decided to limit the analysis to 7 years.

Questions:

1) What is the weakness of using the payback period method to evaluate long-term investments?

2)Assume the manager of the company wanted to live in Miami and intentionally inflated the projected annual cash receipts so that the proposal would be accepted. The proposal would otherwise have been rejected. Explain how the company’s use of a post audit would help to prevent this type of unethical behavior.

Answer 1

Discounted Cash flow from the project

Year	Present Value Factor @ 13% (a)	Inflow (b)	Present Value
1	1 / (1.13) = 0.885	80000	70796.46
2	1 / (1.13) (1.13) = 0.783	115000	90061.87
3	1 / (1.13) (1.13) (1.13) = 0.693	118000	81779.92
4	1 / (1.13) (1.13) (1.13) (1.13) = 0.613	140000	85864.62
5	1 / (1.13) (1.13) (1.13) (1.13) (1.13) = 0.543	155000	84127.79
6	1 / (1.13) (1.13) (1.13) (1.13) (1.13) (1.13) = 0.480	167000	80213.19
7	1 / (1.13) (1.13) (1.13) (1.13) (1.13) (1.13) (1.13) = 0.425	175000	74385.61
	TOTAL		567229.50

cost of the project

Purchase of building = 420000

working capital = 50000

remodel of the store = 100000

Discounted cost = 420000+50000+100000 / 1.13 * 1.13 * 1.13 = $539300 approxx

Discounted payback period = 539300 / 567229.50= 0.95 years approx.

a.

weakness of payback period is that it does not take into consideration time value of money (TVM) concept with it

you can simply under stand it

cost without consider TVM = 420000+50000+100000= 570000

recipt without TVM= 80000+115000+118000+140000+155000+167000+175000= $950000

payback period = 570000 / 950000= 0.6 years

in this case payback period is less means it can cover its cost at much higher pace than compared with discounted payback period

b.

the company’s should use discounted payback period approach that would help to prevent this type of unethical behavior.

Hope you understand the concept

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