Question

What information does the payback period provide?

Suppose Praxis Corporation’s CFO is evaluating a project with the following cash inflows. She does not know the project’s initial cost; however, she does know that the project’s regular payback period is 2.5 years.

Year	Cash Flow
Year 1	$300,000
Year 2	$450,000
Year 3	$400,000
Year 4	$450,000

If the project’s weighted average cost of capital (WACC) is 10%, what is its NPV?

A.) $302,510

B.) $332,761

C.) $317,636

D.) $287,385

Which of the following statements indicate a disadvantage of using the discounted payback period for capital budgeting decisions? Choose all that apply.

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

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

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

Answer 1

The NPV is computed as follows:

The NPV is computed as shown below:

= Initial investment + Present value of future cash flows

Initial investment is computed as follows:

= Year 1 cash flow + Year 2 cash flow + 0.50 x Year 3 cash flow

= $ 300,000 + $ 450,000 + 0.50 x 400,000

= $ 950,000

So, the NPV is computed as follows:

= - $ 950,000 + $ 300,000 / 1.10 + $ 450,000 / 1.10² + 400,000 / 1.10³ + $ 450,000 / 1.10⁴

= $ 302,510 Approximately

The discounted payback period does not take the project’s entire life into account indicate a disadvantage of using the discounted payback period for capital budgeting decisions.

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