Question

ject's NPV at various costs of capital. A project's NPV profile is shown as follows. Identify An NPV profile plots a pro the range of costs of capital that a firm would use to accept and reject this project. NPV (Dollars) 400 300 200 Accept 100 Reject -100 -200 0 2 4 68 10 12 14 16 18 20 COST OF CAPITAL [Percent) The point at which the NPV profile intersects the horizontal axis represents the

Answer 1

1) As per the NPV rule, all projects with postive NPV should be accepted. In the given diagram, NPV is positive in green portion and negative in the purple portion. Therefore, green portion should be accepted and purple portion should be rejected.

The point at which NPV profile intersects the horizontal axis represents the IRR. IRR is the rate at which NPV is zero.

2) Payback period is the period within which the intial cash outflow or initial investment is recovered by the cash inflows of the project.

Conventional payback period

The initial outflow of (-)$6,000,000 is recovered or becomes positive in year 2. So, payback period is beyond year 1 but before the end of year 2 since cumulative cash flow is not zero in year 2 but actually more than that. So, initial cash flow in year 2 is more than required for the payback.

Payback period = 1 year + 1 year x (Cash flow required in Year 2 / Total cash flow in year 2)

or, Payback period = 1 year + 1 year x ($3,600,000 / $5,100,000) = 1.70588 year or 1.71 years

Discounted payback period

Similarly, in this case, payback period is beyond year 1 but before the end of year 2. Only difference between this method and the conventional method is that we use discounted cash flows instead of normal cash flows -

Payback period = 1 year + 1 year x (Discounted cash flow required in year 2 / Total discounted cash flow in year 2)

or, Payback period = 1 year + 1 year x ($3,798,165 / $4,292,568) = 1.8848235 years or 1.88 years

Discounted payback period should be used by the CFO because it takes into account the time value of money by considering discounted cash flows and gives a more accurate measure of the payback period.