Question

1. Silky Smooth Studio (SMS) is considering investing in a movie project. The expected cash flows of the project are given in the table below.

Year	0	1	2	3
Cash Flow	-$100,000	$45,000	$45,000	$45,000

       

The required return of the project is 12 percent.

1. Using Net Present Value as the decision criterion, should SMS invest in this movie? Explain carefully.
2. What is the discounted payback period of this project?   

Answer 1

a. The NPV is computed as shown below:

= Initial investment + Present value of future cash flows

Present value is computed as follows:

= Future value / (1 + r)ⁿ

So, the NPV is computed as follows:

= - $ 100,000 + $ 45,000 / 1.12 + $ 45,000 / 1.12² + $ 45,000 / 1.12³

= $ 8,082.41 Approximately

Since the NPV of the investment is positive, hence we shall invest in this movie as it will lead to increase in the value of the firm by $ 8,082.41.

b. The discounted payback period is computed as shown below:

Discounted Payback period represents the time period in which the initial investment in a project is recovered by discounting the future cash flows, which implies that it takes in to consideration the time value of money concept.

Cumulative discounted cash flows of year 1 and year 2 is computed as follows:

= $ 45,000 / 1.12¹ + $ 45,000 / 1.12²

= $ 76,052.29592

Cumulative discounted cash flows from year 1 to year 3 is computed as follows:

= $ 45,000 / 1.12¹ + $ 45,000 / 1.12² + $ 45,000 / 1.12³

= $ 108,082.4071

It means that the discounted payback period lies between year 2 and year 3, since the initial investment of $ 100,000 is recovered between them. So, the discounted payback period will be computed as follows:

= 2 years + Balance investment to be recovered / Year 3 discounted cash flow

= 2 years + [ ($ 100,000 - $ 76,052.29592) / ( $ 45,000 / 1.12³) ]

= 2 years + $ 23,947.70408 / $ 32,030.11115

= 2.75 years Approximately

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