Question

C&P Trading Inc. is considering a project, initial investment is $260,000. The company board of directors set the maximum requirements of return of pay back 3 years and has set the cost of capital is 10%, below is the cash flow: CF1= $75,800 , CF2= $78,960 , CF3= $82,278, CF4= $117,612. (15')

1. Would you accept the project based on NPV, IRR? (4')
2. Would you accept the project based on Payback rule if project cut-off period is 3 years? (3')
3. How would you explain to your CEO what NPV means? (4')
4. What are advantages and disadvantages of using only Payback method? (4')

Answer 1

Net present value (npv) is the present value of future cash flows from a project net of investment. We will discount future cash flows using cost of capital and subtract the cash outflow required today to get npv.

Npv = -Cash outlay + CF1/(1+r) + CF2/(1+r)^2 + CF3/(1+r)^3 + CF4/(1+r)^4

Where CF1,2,3,4 are cash flows at year 1,2,3,4 end and r is cost of capital

Npv = -260,000 + 75800/1.1 + 78960/1.1^2 + 82278/1.1^3 + 117612/1.1^4

= $16312.55

IRR is that rate of return which makes npv = 0

We can calculate solving this equation

0= -260000+75800/(1+irr) + 78960/(1+irr)^2 + 82278/(1+irr)^3 + 117612/(1+irr)^4

Irr = 12.67%

We can use excel function = irr for this too.

=Irr(-260000,75800,78960,82278,117612) = 12.67%

Payback period is that period in which you get your initial investment amount back, without discounting.

If we add the first 3 years' cash flows, we get $237038 which is less than the initial investment. Thus our payback is more than 3 years. We would not accept the project if payback period is 3 years.

Npv is the difference between net present value of cash inflows and outflows taking into account the cost of capital. If it is positive, then it means we are adding value for shareholders. A firm should not undertake projects with negative npv. It accounts for the time value of money. Only positive npv projects increase value for the firm.

Advantages of payback method -

It is easy to understand and calculate. Its simplicity is the biggest advantage.

Focus on early payback can enhance liquidity.

Disadvantages

It ignores cash flows after payback period

It ignores profitability. Just because a project has short payback period doesn't mean it is profitable.

It ignores the time value of money