Question

Between NPV and payback period, which capital budgeting technique should the CEO consider in making the decision and why? Which of these projects should be chosen? Discuss.

Sydney investment:

Formula	Year (n)	0	1	2	3	4
	Cash flow (CF)	-2,000,000	800,000	1,000,000	1,000,000	1,000,000
	Discount factor @ 10%	1.000	0.909	0.826	0.751	0.683
CF*Discount factor	Discounted cash flow (DCF)	-2,000,000	727,272.73	826,446.28	751,314.80	683,013.46
Sum of all DCFs	NPV	988,047.26
Formula	Year (n)	0	1	2	3	4
	Cash flow (CF)	-2,000,000	800,000	1,000,000	1,000,000	1,000,000
CFn + CCFn-1	Cumulative Cash flow (CCF)	-2,000,000	-1,200,000	-200,000	800,000	1,800,000
(-CCFYear2/CFYear3) + 2	Payback period (in years)				2.20

Melbourne investment:

Formula	Year (n)	0	1	2	3	4
	Cash flow (CF)	-2,000,000	1,000,000	1,000,000	700,000	700,000
1/(1+discount rate)^n	Discount factor @ 10%	1.000	0.909	0.826	0.751	0.683
CF*Discount factor	Discounted cash flow (DCF)	-2,000,000	909,090.91	826,446.28	525,920.36	478,109.42
Sum of all DCFs	NPV	739,566.97
Formula	Year (n)	0	1	2	3	4
	Cash flow (CF)	-2,000,000	1,000,000	1,000,000	700,000	700,000
CFn + CCFn-1	Cumulative Cash flow (CCF)	-2,000,000	-1,000,000	0	700,000	1,400,000
(-CCFYear1/CFYear2) + 1	Payback period (in years)			2.00

Answer 1

Between NPV and payback period, the CEO should consider NPV in making the capital budgeting decision because NPV considers the time value of money, risk of the project and effect of inflation. NPV also takes into consideration all the cash flows during the life of the project. it tells that how much profit project will generate in present value terms at the given risk.

Payback period tells the time project will take to recover initial investment of the project. it does not consider cash flows and benefits occur beyond payback period. It does not consider time value of money and risk of the project.

Project Sydney investment should be chosen because its NPV of 988,047.26 is higher than NPV of 739,566.97 of Melbourne investment. higher NPV means higher profits.