Question

Darfield Trading Incorporated is considering to invest in a new project. The initial investment for the project is $5,000,000 and it is expected to provide operating cash inflows of $1,800,000 in year 1, $1,900,000 in year 2, $1,700,000 in year 3, and $1,800,000 in year 4. Calculate the payback period for the new project. Calculate the discounted payback period assuming the firm’s cost of capital is 8 percent. Should Darfield Trading invest in the new project if the company has a policy that any new project must have a payback period of less than 3 years AND discounted payback period of less than 4 years? Which method is better, normal payback period or discounted payback period? Explain your answer.

Answer 1

a)
Year	Cash flow	Cumulative Cash flow
0	$ (5,000,000.00)	$ (5,000,000.00)
1	$  1,800,000.00	$ (3,200,000.00)
2	$  1,900,000.00	$ (1,300,000.00)
3	$  1,700,000.00	$     400,000.00
4	$  1,800,000.00
Payback period = 2 years + 1300000/1700000	2.76	Years
Discounted Payback
Year	Cash flow	PV @ 8%	Discounted Cash flow	Cumulative Cash flow
0	$ (5,000,000.00)	1.0000	$       (5,000,000.0)	$     (5,000,000.00)
1	$  1,800,000.00	0.9259	$         1,666,666.7	$     (3,333,333.33)
2	$  1,900,000.00	0.8573	$         1,628,943.8	$     (1,704,389.57)
3	$  1,700,000.00	0.7938	$         1,349,514.8	$        (354,874.77)
4	$  1,800,000.00	0.7350	$         1,323,053.7	$          968,178.97
Discounted Payback period = 3 years + (358,874.777/$1,323,053.7	3.27	Years
Yes , Darfield Trading should  invest in the new project since its meeting the criteria.
Discounted payback method is better than the normal payback period because it takes into account the present value of future cash inflows. The discounted payback period will be longer than the normal  payback period and it also  gives a more accurate estimate on when the company can expect a return on its investment.