Question

According to the payback rule, an investment is accepted if its calculated payback period is less than or equal to a prespecified number of years. Consider the investment below if analysed using the NPV rule. The initial cost is R6-million and the cost of capital is 10% per annum. It has been decided that the project should be accepted if the payback period is three years or less. Using the payback rule, should this project be undertaken?

Year Cash Flow Generated

Year 1 R2-million, Year 2 R2.25-million, Year 3 R2.2-million, Year 4 R2.1-million.

Answer 1

Total cash inflows is = 2+2.25+2.2+2.1 =8.55

In payback period is = i.e how much time it takes to cover initial investment of 6 million

Therefore cash inflows of project in 2+2.25+2.2=6.45

In payback period without considering time value of money year cash inflows, simply it takes 3 years or

in 3rd year cash inflow 2.2 = 12 months

We required (6-4.25). 1.75 cash inflow how may months?

= 1.75*12÷2.2 = 9.545 months

Therefore payback period is 2 years 9.545 months.

NPV calculation:

@10% cost of capital year 1 = 0.909*2 =1.818

Year 2 = 0.826*2.25=1.8585

year 3= 0.751*2.2 =1.6522

year 4 = 0.6830*2.1=1.4343

total cash inflows =6.763

Less initial investment=6

Therefore npv= 0.763 million

Positive npv,we can accept project.