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.

Year	Cash Flow
Year 1	$275,000
Year 2	$475,000
Year 3	$400,000
Year 4	$450,000

If the project’s weighted average cost of capital (WACC) is 10%, the project’s NPV (rounded to the nearest dollar) is:

$270,400

$345,511

$240,355

$300,444

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 time value of money into account.

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

The payback period is calculated using net income instead of cash flows.

Answer 1

Payback period 2.5 years means initial investment is recovered in 2.5 Years

Initial investment = CF in two years + [ 0.5 * CF in Year 3 ]

= 275000 + 475000 + [ 0.5 * 400000 ]

= 275000 + 475000 + 200000

= 950000

NPV = PV of Cash Inflows - PV of Cash Outflows

Year	Cf	PVF @10%	Disc CF
0	$ -9,50,000.00	1.0000	$ -9,50,000.00
1	$ 2,75,000.00	0.9091	$ 2,50,000.00
2	$ 4,75,000.00	0.8264	$ 3,92,561.98
3	$ 4,00,000.00	0.7513	$ 3,00,525.92
4	$ 4,50,000.00	0.6830	$ 3,07,356.05
NPV			$ 3,00,443.96

OPtion D is correct.

Payback period doesn't consider the time value of Money and It considers the CFs till initial Investment is recovered.

However it considers CFs Rather than Net Income.

Hence 1st and 2nd statments are disadvantages of PBP.