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

NPV = sum of present values of cash flows

present value of each cash flow = cash flow / (1 + cost of capital)ⁿ

where n = number of years after which the cash flow occurs

NPV is $16,313

IRR is calculated using IRR function in Excel. IRR is 12.67%

Yes, the project would be accepted  based on NPV, IRR because NPV is positive and IRR is higher than cost of capital.

Payback period is the time taken for the cumulative cash flows to turn positive. As seen in the table, payback period is more than 3 years. Therefore, the project would not be accepted based on payback period.

NPV measures the excess of the present value of cash inflows over the initial investment. Therefore, NPV is the value generated by the project. If NPV is positive, it means that the project creates value, and if NPV is negative, it means that the project destroys value.

Advantages of using only Payback method are :

• Simple to use and calculate
• Measures how quickly the investment is recovered. This is useful for projects whose capital recovery is uncertain
• Does not require calculating the cost of capital

Disadvantages of using only Payback method are :

• It does not consider the time value of money
• It does not consider cash flows beyond the payback period
• It does not tell you whether a project generates value or destroys value