Question

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. If the project's weighted average cost of capital (WACC) is 8%, what is its NPV? Year Cash Flow Year 1 $300,000 Year 2 $400,000 Year 3 $425,000 Year 4 $450,000 $451,626 $376,355 $395,173 $432,808 Which of the following statements indicate a disadvantage of using the discounted payback period for capital budgeting decisions? Check all that apply. O 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. The discounted payback period is calculated using net income instead of cash flows.

Answer 1

Payback period=Last period with a negative cumulative cash flow+(Absolute value of cumulative cash flows at that period/Cash flow after that period).

Hence initial cost=300,000+400,000+(425,000*0.5)=912500

Present value of inflows=cash inflow*Present value of discounting factor(rate%,time period)

=300,000/1.08+400,000/1.08^2+425,000/1.08^3+450,000/1.08^4

=1288855.44

NPV=Present value of inflows-Present value of outflows

=1288855.44-912500

=$376355(Approx).

The correct option is :

The discounted payback method does not take the project's entire life into account.

Discounted payback method considers cash flows only till the time period the initial investment is recovered and not cash flows beyond that period.