Question

B. Sunshine Bed & Breakfast is considering a capital budgeting project that involves significant expansion of its room and kitchen facilities. The cash flow stream expected from this capital budgeting project is below. 1. Compute the payback period. What are advantages and disadvantages of this approach to evaluating a capital budgeting project? 2. Compute the net present value of this capital budgeting project. Assume a required rate of return of 15%. 3. Should the project be accepted? Explain your answer.

Sunshine Bed & Breakfast Room and Kitchen Expansion
Year	Cash Flows
0	-$500,000
1	$100,000
2	$150,000
3	$250,000
4	$300,000

Answer 1

1. The payback period denotes the time period in which the initial investment in a project is recovered.

The cumulative value of the first 3 years cash flow is computed as follows:

= $ 100,000 + $ 150,000 + $ 250,000

= $ 500,000

As can be seen, the initial investment of $ 500,000 is recovered in 3 years. Hence the payback period is 3 years.

Advantages of payback period are as follows:

It gives an estimate of the time period in which the initial investment in a project will be recovered.

Since the calculation involved in the computation of the payback period is relatively easy, hence it is considered relatively a easier and less time consuming method.

Disadvantages of payback period are as follows:

Since the payback period does not takes in to account the time value of money in to consideration , hence the results provided by the payback period are not seen as a clear picture when compared to the discounted payback period.

Since the payback period considers only the cash flows till the initial investment in a project is recovered, hence the cash flows which occurs after the period when the investment is recovered are ignored.

2. The net present value is computed as shown below:

= Initial investment + Present value of future cash flows

Present value of cash flows is computed as follows:

Present value = Future value / (1 + r )ⁿ

So, the net present value will be:

= - $ 500,000 + $ 100,000 / 1.15¹ + $ 150,000 / 1.15² +$ 250,000 / 1.15³ +$ 300,000 / 1.15⁴

= $ 36,283.10 Approximately

Whenever a project's NPV is positive it denotes that the net cash flows generated from the project will result in a positive value for a firm and as a result will add value to the firm. Hence the project shall be accepted.

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