Question

5. The NPV and payback period

What information does the payback period provide?

Suppose Omni Consumer Products’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	$500,000
Year 3	$500,000
Year 4	$450,000

If the project’s weighted average cost of capital (WACC) is 7%, what is its NPV?

$415,274

$394,510

$332,219

$352,983

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 time value of money into account.

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

Answer 1

The NPV is computed as shown below:

= Initial investment + Present value of future cash flows

Present value is computed as follows:

= Future value / (1 + r)ⁿ

First of all we shall calculate the initial investment as follows:

As given in the question that the payback period is 2.5 years, it clearly indicates that it has taken 2.5 years for the project to recover the initial investment

So, the initial investment will be:

= Year 1 cash flow + Year 2 cash flow + 0.50 x Year 3 cash flow

= $ 350,000 + $ 500,000 + 0.50 x $ 500,000

= $ 1,100,000

So, the project's NPV will be as follows:

= - $ 1,100,000 + $ 350,000 / 1.07 + $ 500,000 / 1.07² + $ 500,000 / 1.07³ + $ 450,000 / 1.07⁴

= $ 415,274 Approximately

The discounted payback period is computed by taking the discounted cash flows which means it takes in to time value of money concept in to consideration.

However, it takes the discounted cash flows till the time period in which the same will be enough to recover the initial investment of the project.

So, the correct answer is option of The discounted payback period does not take the project’s entire life into account indicate a disadvantage of using the discounted payback period for capital budgeting decisions.

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