Question

Nader International is considering investing in two assets- A and B. The initial outlay and annual cash flows for each asset are shown in the following table assets' assumed 5 year-lives. The firm requires a 12% return on each of these equally risky assets. Nader's maximum payback period is 2.5 years, and its maximum discounted payback period is 3.25 years.

Asset A ($200,000) Asset B ($180,000)

Year (t) Cash Flow (CFt) Cash Flow (CFt)

1 $70,000   $80,000

2 $80,000 $90,000

3 $90,000 $30,000

4 $90,000 $40,000

5 $100,000 $40,000

A. Calculate the payback period for each asset, assess its acceptability, and indicate which asset is best in terms of this criterion.

B. Calculate the discounted payback for each asset, assess its acceptability, and indicate which asset is best in terms of this criterion.

C. Compare and contrast your findings in parts (A) and (B). Assuming that they are mutually exclusive, which asset would you recommend to Nader? Why?

Answer 1

(a);

Year	Cash flow of A	Cash flow of B	Cumulative cash flow of A	Cumulative cash flow of B
-	-               200,000	-               180,000	-           200,000	-              180,000
1	70,000	80,000	-           130,000	-              100,000
2	80,000	90,000	-              50,000	-                10,000
3	90,000	30,000	40,000	20,000
4	90,000	40,000
5	100,000	40,000

Thus payback of A = 2 + 50,000/90,000 = 2.56 years

Payback of B = 2+ 10,000/30,000 = 2.33 years

Thus Asset B is best as its payback < payback of A and also because its payback is less than 2.5 years which is the laid out criteria.

(b): Here we will discount all the cash flows using the discount rate of 12%.

Year	Cash flow of A	Cash flow of B	1+r	Discounted CF of A	Discounted CF of B	Cumulative discounted cash flow of A	Cumulative discounted cash flow of A
-	-               200,000	-               180,000	1.12	-                   200,000.00	-                180,000.00	-               200,000.00	-                       180,000.00
1	70,000	80,000		62,500.00	71,428.57	-               137,500.00	-                       108,571.43
2	80,000	90,000		63,775.51	71,747.45	-                  73,724.49	-                         36,823.98
3	90,000	30,000		64,060.22	21,353.41	-                    9,664.27	-                         15,470.57
4	90,000	40,000		57,196.63	25,420.72	47,532.36	9,950.15
5	100,000	40,000		56,742.69	22,697.07

Thus discounted payback of A = 3+ 9664.27/57196.63 = 3.17 years

Of B = 3 + 15470.57/25420.72 = 3.61 years

Thus Asset A is best as its discounted payback < discounted payback of B and also because its payback is less than 3.25 years which is the laid out criteria.

(c): Findings are different in A and B because of the fact that in B time value of money is considered. Assuming both are mutually exclusive I will recommend Asset A because it is better when using discounted payback as a tool. It should be noted that discounted payback is a better tool as it takes into account the time value of money.