Question

Suppose you are evaluating a project with the expected future cash inflows shown in the following table. Your boss has asked you to calculate the project's net present value (NPV). You don't know the project's initial cost, but you do know the project's regular, or conventional, payback period is 2.50 years. If the project's ~WACC~ is 7%, the project's NPV (rounded to the nearest dollar) is: Year Cash Flo Year 1 $300,000 Year 2 $450,000 Year 3 $450,000 Year 4 $425,000 O $448,484 O $467,983 O $331,488 O $389,986 Which of the following statements indicate a disadvantage of using the regular payback period (not the discounted payback period) for capital budgeting decisions? Check all that apply The payback period does not take the project's entire life into account. The payback period does not take the time value of money into account. The payback period is calculated using net income instead of cash flows.

Answer 1

Solution:

As per the Information given in the question the payback period of the project is 2.5 years.

Payback period is the time period taken by a project to recover its initial investment.

This implies that the Initial Investment is recovered from the Cash Flows of Year 1, Cash flows of Year 2 and half of the cash Flow of year 3

Thus the Initial Investment in the project = $ 300,000 + $ 450,000 + ($ 450,000 *0.5)

= $ 300,000 + $ 450,000 + $ 225,000 = $ 975,000

Hence, the Initial Investment in the project = $ 975,000

The Net present value of the Project at WACC 7% with Initial Investment of $ 975,000 is = $ 389,986

Thus the NPV is option 4 = $ 389,986

Please find the attached screenshot of the excel sheet containing the detailed calculation for the solution.

The following are the disadvantages of using the regular Payback period for capital budgeting decisions.

Disadvantages of regular Payback Period

The Payback period does not take the project’s entire life into account.

The payback period does not take the time value of money into account.

Hence, check only the above

The third statement is not a disadvantage as the statement itself is false.

The payback period is not calculated using the net income. It is calculated using the cash flows only.

17.04.2019 Excel HOME INSERT PAGE LAYOUT FORMULAS DATA REVIEW VIEW Statement showing calculation of Net Present value of the Project Sl.No. Particulars Discounted Cash Inflows or Present value of cash Inflows Amount PVF @ 7 % 1 Cash Inflow Year 1 2 Cash Inflow Year 2 3 Cash Inflow Year 3 4 Cash Inflow Year 4 0.9346| $ 0.8734 $ 0.8163 $ 0.7629 S 4 300,000.00 450,000.00 450,000.00 425,000.00 280,373.83 393,047.43 367,334.04 324,230.47 1,364,985.77 975,000.00 389,985.77 389,986.00 Total of Present value of cash Inflows (A Initial Investment (B Net Present value of the Proiect (A) (B 10 8 Net Present value of the Project ( Rounded of the nearest whole number) $ 12