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 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 2 475,000 Year 3 500,000 Year 4 450,000 If the project's weighted average cost of capital (WACC) is 7%, what is its NPV? O $418,438 O $397,516 O $481,204 O $502,126

Answer 1

The lower the payback, other things constant, the greater the project's liquidity

The NPV is computed as shown below:

= Initial investment + Present value of future cash flows

Initial investment is computed as follows:

Since the payback period is 2.5 years, it implies that the project's initial investment is recovered 2.5 years. So, the initial investment is computed as follows:

= $ 350,000 + $ 475,000 + 0.50 x $ 500,000

= $ 1,075,000

Present value is computed as follows:

= Future value / (1 + r)ⁿ

So, the NPV is computed as follows:

= - $ 1,075,000 + $ 350,000 / 1.07 + $ 475,000 / 1.07² + $ 500,000 / 1.07³ + $ 450,000 / 1.07⁴

= $ 418,438 Approximately

The discounted payback period does not take in to account the project's entire life is a correct statement.

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