Question

The conventional payback period ignores the time value of money, and this concerns Cute Camel’s CFO. He has now asked you to compute Alpha’s discounted payback period, assuming the company has a 8% cost of capital. Complete the following table and perform any necessary calculations. Round the discounted cash flow values to the nearest whole dollar, and the discounted payback period to two decimal places. For negative values, be sure to include a minus sign in your answer. For full credit, complete the entire table.

	year 0	year1	year2	year3
cash flow	-4,500,000	1,800,000	3,825,000	1,575,000
discounted cash flow
cumulative discounted cash flow
discounted payback period	?years

Which version of a project’s payback period should the CFO use when evaluating Project Alpha, given its theoretical superiority?

A.The discounted payback period

B. The regular payback period

One theoretical disadvantage of both payback methods—compared to the net present value method—is that they fail to consider the value of the cash flows beyond the point in time equal to the payback period.

How much value does the discounted payback period method fail to recognize due to this theoretical deficiency?

A.$4,529,607

B.$1,696,274

C.$2,916,953

D.$1,250,286

Answer 1

Since normal payback period does not take into account the time value of money, discounted payback period is superior approach
Year	Cashflow	PV factor	Discounted Cashflow	Cumulative discounted cashflow
0	(4,500,000)	1.0000	(4,500,000)	(4,500,000)
1	1,800,000	0.9259	1,666,667	(2,833,333)
2	3,825,000	0.8573	3,279,321	445,988
3	1,575,000	0.7938	1,250,286	1,696,273
		NPV	1,696,273
	Discounted payback period=	1+2833333.33/3279320.99
	Discounted payback period=	1.864
	Discounted payback period is the period when initial outlfow is recovered.
	Disadvantage of this method is that this method does not consider the additional cash generated by project which is reflected by its NPV
	Hence option b is correct