Question

23. Payback and NP a. What is the payback period on each of the following projects? Net Present Value and Other Investment Criteria 371 Cash Flows, Dellars Project Time: 1 5,000 1,000 000 3,000 1,000 1,000 2,000 3,000 5.000 1.000 1.000 3000 +5,000 b. Given that you wish to use the payback rule with a cutoff period of 2 years, which proj- ects would you accept e. If you use a cutoff period of 3 years, which projects would you accept? d. If the opportunity cost of capital is 10 percent, which projects have positive NPVs? "Payback gives too much weight to cash flows that occur after the cutoff date." True or alse?

Answer 1

Answer a:

Payback period:

Project A = 3 Years

Project B = 2 Years

Project C = 3 Years

Project A Year Cash Flows Cumulative cash flow Payback period 1000 1000 3000 0 5000 3000 0 3 Years Project B Year Cash Flows Cumulative cash flow Payback period 1000 0 1000 3000 1000 1000 0 2 Years Project C Year Cash Flows Cumulative cash flow Payback period 1000 1000 3000 3000 5000 3 Years

Answer b:

If cut off = 2 years, only Project B will be accepted.

Answer c:

If opportunity cost of capital =10%, Project B and Project C will have positive NPVs.

Workings are as below:

Project A Year Cash Flows Cumulative cash flow Payback period NPV (cost of capital-10%) | ($1,010.52) 5000 1000 1000 3000 0 5000 3000 0 3lYears Project B Year Cash Flows Cumulative cash flow Payback period NPV (cost of capital-10%) 1000 0 1000 3000 1000 1000 0 5000 2 Years $3,378.12 Project C Year Cash Flows Cumulative cash flow Payback period NPV (cost of capital-10%) 5000 1000 1000 3000 5000 3000 5000 3lYears $2,404.55

Answer d:

Correct answer is:

False

Explanation:

Payback period does not consider cash flows that occur after the cut-off date. Payback period considers the period within which initial investment is recovered; as such it does not give any weightage to cash flows that occur after the cut-off date.