Question

2.     Jane plans to open a bike repair shop in Scarborough. She will operate the shop for five years and then she plans to move to the coast. The repair equipment will cost $95,000 and Jane expects the after tax cash flows to be $26,200 a year.

a.  What is the payback period for the project?

b.  Assuming a required rate of return of 9.5% for her project what is the IRR?

c.   What are the advantages/disadvantages of using each method? Explain.

Answer 1

2. The cost of the equipment is ( $95,000)

The after tax cash flows are $26,200 per year for 5 years

a. The payback period for the project is :

= 3 + ( $95,000 - $78,600) / $26,200

= 3.62

the payback period is 3.62 years.

b. The IRR of the project is :

CFO = ( $95,000)

CF1 = $26,200

CF2= $26,200

CF3= $26,200

So, the IRR for the project is ,

( $95,000 ) + $26,200/ (1 + IRR)^1 + $26,200/ (1 + IRR)^2 + ..... = 0

So, the IRR is = 11.76%

c. Advantages : The payback period method is simple and easy to understand.

Disadvantages : It ignores the time value of money .

The IRR method :

Advantages : It considers the time value of money. Simple to use and understand. It does not require a required rate of return as it considers the IRR as the required rate of return .

Disadvantages : It ignores the size of the project and ignores future costs as well, it only considers the project's cash flows with the existing costs of the projects.