Question

Along with the questions, is the first one shorter or longer?

A project's payback period (PB) indicates the number of years required for a project to recover its initial investment using its operating cash flows. As the theoretical soundness of the conventional (undiscounted) PB technique was criticized, the model was modified to incorporate the time value of money-adjusted operating cash flows to create the discounted payback method. While both payback models continue to reflect faulty ranking criteria, they do provide important (useful) information regarding a project's liquidity and riskiness. In general, the shorter the payback, other things constant, the greater the project's liquidity. 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 mWACC~ is 10%, the project's NPV (rounded to the nearest dollar) is: Year Cash Flo Year $300,000 Year 2 $475,000 Year 3 $425,000 Year 4 $450,000 O $334,899 O $304,454 O $319,677 $365,345 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

Shorter the payback, greater is the liquidity.

So, the first answer "Shorter" is correct.

Question 1

Conventional payback period refers to simple payback period.

In this case, simple payback period is 2.5 years. This means the project has taken 2.5 years to recover it's initial investment.

Cash generated by the project in 2.5 years = C₁ + C₂ + C₃ / 2 = 300,000 + 475,000 + 425,000 / 2 = 987,500

Please note that i have assumed only half of cash flow in year 3 (represented by C₃) will be realized by the middle of year (i.e. year 2.5).

Hence, the initial investment in the project = C₀ = -987,500

Discount rate = WACC = 10%.

Please see the table below for NPV calculation. The linkage column explains how each row has been calculated.

Year, N		0	1	2	3	4
Cash flows	Ci	(987,500)	300,000	475,000	425,000	450,000
Discount rate	WACC	10%
PV factor	(1 + WACC)(-N)	1.0000	0.9091	0.8264	0.7513	0.6830
PV of Cash flows	C x PV factor	(987,500)	272,727	392,562	319,309	307,356
NPV	Sum of all PV	304,454

Hence, the correct answer is second option representing $ 304,454

Question 2

The regular payback period doesn't take into account the cash flows occurring over the entire life of the project. It doesn't take into account the time value of money.

Hence, first and second options both are correct and should be ticked.

The third option is wrong. Payback period takes into account the cash flows and not accounting income.