Question

Sigma Company is examining the cash flows of the capital budgeting project shown below. The project is expected to cost $400,000. Sigma has a required rate of return of 12%, and a maximum acceptable payback period of 3 years.

0	1	2	3	4	5
($400,000)	$150,000	$150,000	$200,000	$100,000	$100,000

a. Calculate the NPV of the project. Based on the NPV analysis, should Sigma accept the project? Why or why not?

b. Calculate the payback period of the project. Based on the calculated payback, should Sigma accept the project? Why or why not?

Answer 1

a.
Net present value	Present value of cash inflow - Present value of cash outflow
Year	Cash flow	Discount factor @ 12%		Present value
0	-$400,000	1.00000	1/(1.12^0)	-$400,000.00
1	$150,000	0.89286	1/(1.12^1)	$133,928.57
2	$150,000	0.79719	1/(1.12^2)	$119,579.08
3	$200,000	0.71178	1/(1.12^3)	$142,356.05
4	$100,000	0.63552	1/(1.12^4)	$63,551.81
5	$100,000	0.56743	1/(1.12^5)	$56,742.69
Net present value				$116,158.20
Thus, net present value of project is $116,158.20
NPV of project is positive and thus sigma should accept the project
b.
Payback period is the number of years it takes for project to recover its initial investment
Year	Cash flow	Cumulative cash flow
0	-$400,000	-$400,000
1	$150,000	-$250,000
2	$150,000	-$100,000
3	$200,000	$100,000
4	$100,000	$200,000
5	$100,000	$300,000
Payback period	2 years + (100000/200000)
Payback period	2.5	years
The payback period is less than 3 years and thus Sigma should accept the project