Question

Payback period essentially provides the number of years it would take for a project to recover the initial investment from its operating cash flows. As the model was criticized, the model evolved incorporating time value of money to create the discounted payback method. The models still reflected faulty ranking criteria but they provided important information about liquidity and risk.

Cash flows expected in the distant future are more/less risky than cash flows received in the near-term—which suggests that the payback period can also serve as an indicator of project risk.

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	500,000
Year 3	475,000
Year 4	400,000

If the project’s weighted average cost of capital (WACC) is 8%, what is its NPV?

$289,025

$391,033

$340,029

$306,026

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

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

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

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

Answer 1

Answer a.

Cash flows expected in the distant future are more risky than cash flows received in the near-term—which suggests that the payback period can also serve as an indicator of project risk.

Answer b.

Payback Period = 2.50 years

Initial Investment = $300,000 + $500,000 + 50% * $475,000
Initial Investment = $1,037,500

WACC = 8%

Net Present Value = -$1,037,500 + $300,000/1.08 + $500,000/1.08^2 + $475,000/1.08^3 + $400,000/1.08^4
Net Present Value = $340,029

Answer c.

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