Question

7. The NPV and payback period

What information does the payback period provide?

Suppose you are evaluating a project with the expected future cash inflows shown in the following table. Your boss has asked you to calculate the project’s net present value (NPV). You don’t know the project’s initial cost, but you do know the project’s regular, or conventional, payback period is 2.50 years.

Year	Cash Flow
Year 1	$325,000
Year 2	$425,000
Year 3	$500,000
Year 4	$425,000

If the project’s weighted average cost of capital (WACC) is 10%, the project’s NPV (rounded to the nearest dollar) is:

$343,895

$281,369

$359,527

$312,632

Which of the following statements indicate a disadvantage of using the regular payback period (not the discounted payback period) for capital budgeting decisions? Check all that apply.

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

The payback period does not take the project’s entire life into account.

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

Answer 1

The payback period method provides the time period within which the initial investment is recovered.

Payback period=Last period with a negative cumulative cash flow+(Absolute value of cumulative cash flows at that period/Cash flow after that period).

Hence initial cost=325000+425000+(500,000*0.5)

=$1,000,000

Present value of inflows=cash inflow*Present value of discounting factor(rate%,time period)

=325000/1.1+425000/1.1^2+500,000/1.1^3+425000/1.1^4

=1312632.33

NPV=Present value of inflows-Present value of outflows  

=1312632.33-1,000,000

=$312632(Approx)

The payback period considers cash flows only till the time period the initial investment is recovered and not cash flows after that period.It also does not consider time value of money to bring cash flows to present terms.

Hence the correct option is:

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

The payback period does not take the project’s entire life into account.