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.

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

Answer 1

Answer a.

Net Present Value:

Cost of Capital = 10%

Net Present Value = -$260,000 + $75,800/1.10 + $78,960/1.10^2 + $82,278/1.10^3 + $117,612/1.10^4
Net Present Value = $16,312.55

The company should accept this project as NPV is positive.

Internal Rate of Return:

Let IRR be i%

Net Present Value = -$260,000 + $75,800/(1+i) + $78,960/(1+i)^2 + $82,278/(1+i)^3 + $117,612/(1+i)^4
0 = -$260,000 + $75,800/(1+i) + $78,960/(1+i)^2 + $82,278/(1+i)^3 + $117,612/(1+i)^4

Using financial calculator, i = 12.67%

Internal Rate of Return = 12.67%

The company should accept this project as IRR is higher than Cost of Capital.

Answer b.

Payback Period:

Company can recoup initial investment of $237,038 ($75,800 + $78,960 + $82,278) in first 3 years and remaining $22,962 ($260,000 - $237,038) in fourth year.

Payback Period = 3 + $22,962 / $117,612
Payback Period = 3.20 years

The company should not accept this project as payback period is more than cut-off period.

Answer c.

NPV is the net value of future cash flows in term of today’s dollar.

Answer d.

Advantages of Payback Method:
Easy to calculate
Focus on early payback period
Disadvantages of Payback Method:
Does not take time value of money into consideration
Does not consider cash flows beyond payback period.