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1. What are disadvantages of Payback Period method used in capital budgeting. 2. A project has...

1. What are disadvantages of Payback Period method used in capital budgeting.

2. A project has an initial cost of $1000 and $450 cash inflow each year for 4 years with a discount rate of 10%. What is its payback period? What is its discounted payback period?

Solutions

Expert Solution

1. payback period is a capital budgeting technique which allows you to find out the time in which your project will be able to cover its initial investment with the given cash flows.

Disadvantages of Payback Period Method -

  • Time value of money is ignored - The concept of time value of money is ignored in Payback period method. Time value of money explalines that the money currently you have is much more valuable then having the same money in future. As money today with you has potential to earn interest if reinvested.
  • Profitability of project is Ignored - The project which has shorter payback period is good for the company but it is not Certain to be profitable. for example if the future cashflow reduces the return on that project will also be reduced hence it will not be viable after payback period ends.

2. Calculation Of payback period

Given -

Initial Investment = $1000

Cash Flow = $450

Time = 4 Years

Years Cash Flows Cumulative Cash flows
0 ($1000) -

1

 $450 450
2 $450

450+450 = $900
3 $450

900+450 = $1350
4 $450

1350+450 = $1800

As we can see that in whole 2 years we got $900 out of $1000 and still $100 is left to be completed which we can get from the next year cash flow (i.e 3rd year)

Thererfore -

= 2 Years + (1000 - 900) / 450

= 2Years + 100 / 450

= 2.22 Years or (2 years 2.6 months)

Calculation Of discount Payback Period

Years Cash Flows PV Factor

Disc. Cash Flow

= CF * PV factor

 Cumulative Disc. Cash Flows
0 ($1000)

1

 (1000) -
1 $450

1 / (1+ .10)1

=0.9090

 409.05 409.05
2 $450

1 / (1+0.10)2

= 0.8264

 371.88 409.05 + 371.88 = 780.93
3 $450

1 / (1+.10)3

= 0.7513

 338.085 780.93 + 338.085 = 1119.015
4 $450

1 / (1+.10)4

= 0.6830

 307.35 1119.015 + 307.35 = 1426.365

As we can see that in whole 2 years we got $780.93 out of $1000 and still $219.07 is left to be completed which we can get from the next year cash flow (i.e 3rd year)

Therefore

= 2 Year + (1000 - 780.93) / 338.085

= 2 Years + 219.07 / 338.085
= 2 .6479 Years Or 2 Years 7.77 Months

jeff jeffy answered 1 year ago
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