Question

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 ABC Telecom Inc.’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	$375,000
Year 2	450,000
Year 3	400,000
Year 4	450,000

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

$330,086

$310,670

$446,588

$388,337

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 does not take the project’s entire life into account.

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.

Answer 1

shorter the payback , greater the projects liquidity

NPV = -initial investment + PV of future cash flows

Present value = Future value/(1+i)^n

i = interest rate per period

n= number of periods

=>

Initial investment = 375000 + 450000 + 0.5 * 400000

= 1025000

NPV = -1025000 + 375000/1.07 + 450000/1.07^2 + 400000/1.07^3 + 450000/1.07^4

= 388336.71

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