Question

South West Industries is considering a project which has the following cash flows:

Year	Cash Flow
0	?
1	$4,000
2	3,000
3	3,000
4	1,500

The project has a payback period of 2.5 years. The firm’s cost of capital is 12 percent.

1. What is the project’s net present value (NPV).

2. What does the NPV rule advise regarding this investment opportunity?

Answer 1

Payback period:

Payback period is the period in which initial investment is recovered.

PBP = Year in which least +ve Closing Balance + [ Closing balance at that year / Cash flow in Next Year ]
If Actual PBP > Expected PBP - Project will be rejected
Actual PBP

Payback period 2.5 Years means AMount is recovered in 2.5 Years

Initial Investment = $ 4000 + $ 3000 + 0.5 ( $ 3000 )

= $ 4000 + $ 3000 + $ 1500

= $ 8500

NPV :
NPV is the difference between Present value of Cash Inflows and Present value of cash outflows.

NPV = PV of Cash Inflows - PV of Cash Outflows
If NPV > 0 , Project can be accepted
NPV = 0 , Indifference point. Project can be accepted/ Rejected.
NPV < 0 , Project will be rejected.

Year	CF	PVF @12 %	Disc CF
0	$         -8,500.00	1.0000	$         -8,500.00
1	$          4,000.00	0.8929	$           3,571.43
2	$          3,000.00	0.7972	$           2,391.58
3	$          3,000.00	0.7118	$           2,135.34
4	$          1,500.00	0.6355	$              953.28
NPV			$              551.63

As Project has +ve NPV, we can invest in this project.