Question

What information does the payback period provide?

Payback period essentially provides the number of years it would take for a project to recover the initial investment from its operating cash flows. As the model was criticized, the model evolved incorporating time value of money to create the discounted payback method. The models still reflected faulty ranking criteria but they provided important information about liquidity and risk.

The   the payback, other things constant, the greater the project’s liquidity.

Suppose Praxis Corporation’s CFO is evaluating a project with the following cash inflows. She does not know the project’s initial cost; however, she does know that the project’s regular payback period is 2.5 years.

Year	Cash Flow
Year 1	$350,000
Year 2	400,000
Year 3	475,000
Year 4	400,000

If the project’s weighted average cost of capital (WACC) is 8%, what is its NPV?

$403,181

$350,592

$420,710

$298,003

Which of the following statements indicate a disadvantage of using the discounted payback period for capital budgeting decisions? Check all that apply.

The discounted payback period is calculated using net income instead of cash flows.

The discounted payback period does not take the project’s entire life into account.

The discounted payback period does not take the time value of money into account.

Answer 1

Q. 1). Answer :- Option B). $ 350,592.

Explanation :-

Year	Annual cash inflow	Cumulative cash inflow
1	350000	350000 (350000 + 0)
2	400000	750000 (350000 + 400000)
3	475000	1225000 (750000 + 475000)
4	40000	1625000 (1225000 + 400000)

Payback period of 2.5 Years (given in question) indicates that the invested amount in project (initial cash outflow) will be recovered exactly between Year 2 and Year 3.

Accordingly, Initial cash outflow = (Cumulative cash inflow in Year 2 + Cumulative cash inflow in Year 3) / 2

= (1225000 + 750000) / 2

= 1975000 / 2

= $ 987500.

Present value of cash inflow = 350000 / (1 + 0.08)1 + 400000 / (1 + 0.08)2 + 475000 / (1 + 0.08)3 + 400000 / (1 + 0.08)4

= 350000 / (1.08)1 + 400000 / (1.08)2 + 475000 / (1.08)3 + 400000 / (1.08)4

= ​​​​​​​350000 / 1.08 + 400000 / 1.1664 + 475000 / 1.2597 + 400000 / 1.3605

= 324074 + 342936 + 377074 + 294009

= $ 1338093.

NPV of Project = Present value of cash inflow - Initial cash outflow.

= 1338093 - 987500

= $ 350,593 (Most nearest to $ 350592 mentioned in option B).

Q . 2). Answer :- Option B). The discounted pay back period does not take the project's entire life into account.

Explanation :- In the discounted pay back period method, The income arising after the recovery of initial investment (i.e., after the pay back of original investment) is not considered. The earnings in the entire life of project is not considered. This is major disadvantage of discounted pay back period.

(Time value of money is always considered in discounted pay back period, therefore, The last third statement i.e., Option C is not correct. Further, The first statement i.e., Option A also not represents to any disadvantage as such).