Question

7. The NPV and payback period What information does the payback period provide? Suppose Omni Consumer Products’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 $350,000 Year 2 $400,000 Year 3 $475,000 Year 4 $475,000 If the project’s weighted average cost of capital (WACC) is 9%, what is its NPV? $373,562 $336,206 $317,528 $429,596 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 does not take the time value of money into account. The discounted payback period is calculated using net income instead of cash flows.

Answer 1

The NPV is computed as shown below:

= Initial investment + Present value of future cash flows

Present value is computed as follows:

= Future value / (1 + r)ⁿ

Initial investment is computed as follows:

= $ 350,000 + $ 400,000 + 0.50 x $ 475,000

= $ 987,500

So, the NPV will be as follows:

= - $ 987,500 + $ 350,000 / 1.09 + $ 400,000 / 1.09² + $ 475,000 / 1.09³ + $ 475,000 / 1.09⁴

= $ 373,562 Approximately

The discounted payback period does not take the project’s entire life into account indicate a disadvantage of using the discounted payback period for capital budgeting decisions

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