Question

You are a financial manager at a movie studio and you are considering a potential new film project. This movie is expected to cost $20 million up front (at t=0) and take one year to produce. After that, it is expected to generate positive cash flow of $14 million in the year it is released (at t=2). In year 3, the film is expected to generate $4.2 million as a result of DVD sales, with cash flows decreasing by 25% in perpetuity from then on.

t= 0 m + + CF ($million) -20 4.2 3.15 If your movie studio makes investment decisions based solely on a required payback period of three years, would you make this movie? Yes, the film studio would accept this project as it allows the firm to recoup its initial investment within the required payback period. b. No, the film studio would reject this project as it does not allow the firm to recoup its initial investment within the required payback period. The film should accept this project as its cash flows fit the requirement that all negative cash flows are received before any positive cash flows. There is not enough information to answer this question.

Answer 1

Payback Period is the time in which we will regain our initial investment.

Here, initial investment = $ 20 Mn

Simple payback period:

Sum of cashflows in years

For 3 years (as this is the benchmark set by company),

Sum of cash flow = 0 + 14 + 4.2 = $ 18.2 Mn

Now, if we calculate discounted payback period for first 3 years, it will less than 18.2 MN, because discounting will reduce the value of cashflows.

Hence, in no way can company regain the initial investment in 3 years.

Hence, Options b - No the firm should reject this project