Question

7. The NPV and payback period What information does the payback period provide? Suppose you are evaluating a project with the expected future cash inflows shown in the following table. Your boss has asked you to calculate the project’s net present value (NPV). You don’t know the project’s initial cost, but you do know the project’s regular, or conventional, payback period is 2.50 years. Year Cash Flow Year 1 $275,000 Year 2 $500,000 Year 3 $450,000 Year 4 $450,000 If the project’s weighted average cost of capital (WACC) is 9%, the project’s NPV (rounded to the nearest dollar) is: a.$288,496 b.$305,466 c.$407,288 d.$339,407 Which of the following statements indicate a disadvantage of using the regular payback period (not the discounted payback period) for capital budgeting decisions? Check all that apply. a.The payback period is calculated using net income instead of cash flows. b.The payback period does not take the time value of money into account. c.The payback period does not take the project’s entire life into account.

Answer 1

Net Present Value (NPV) of the Project

The Net Present Value of the Project = Present Value of annual cash inflows – Initial Investments

Present Value of annual cash inflows

Year	Net Cash Flow ($)	Present Value factor at 9%	Present Value of Cash Flow ($)
1	2,75,000	0.917431	2,52,294
2	5,00,000	0.841680	4,20,840
3	4,50,000	0.772183	3,47,483
4	4,50,000	0.708425	3,18,791
TOTAL			1,339,407

Initial Investment

The payback period is the number of years taken to recover the initial investments of the project. Here the payback period of the project is 2.50 years given, therefore, we can determine the amount of initial investments of the project

Initial Investment of the Project = $275,000 + $500,000 + [$450,000 x 0.50]

= $275,000 + $500,000 + $225,000

= $1,000,000

Therefore, the Net Present Value of the Project = Present Value of annual cash inflows – Initial Investments

= $1,339,407 - $1,000,000

= $339,407

“The Net Present Value (NPV) of the Project will be (d). $339,407”

The following are the correct statements which indicates the disadvantage of using the regular payback period for capital budgeting decisions

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

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

NOTE

The formula for calculating the Present Value Inflow Factor (PVIF) is [1 / (1 + r)ⁿ], where “r” is the Discount Rate/Cost of capital and “n” is the number of years.