Suppose you are evaluating a project with the 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.
The project's annual cash flows are:
|
Year |
Cash Flow |
|---|---|
| Year 1 | $375,000 |
| Year 2 | 550,000 |
| Year 3 | 400,000 |
| Year 4 | 300,000 |
If the project’s desired rate of return is 9.00%, the project’s NPV—rounded to the nearest whole dollar—is (blank)
Which of the following statements indicates a disadvantage of using the regular, or conventional, payback period for capital budgeting decisions? Which all apply?
The payback period does not take into account the time value of money effects of a project’s cash flows.
The payback period does not take into account the cash flows produced over a project’s entire life.
The payback period is calculated using net income instead of cash flows.
Present Value of annual cash inflows
|
Year |
Annual cash flows ($) |
Present Value Factor (PVF) at 9.00% |
Present Value of annual cash flows ($) [Annual cash flow x PVF] |
|
1 |
3,75,000 |
0.91743119 |
3,44,037 |
|
2 |
2,50,000 |
0.84167999 |
2,10,420 |
|
3 |
4,00,000 |
0.77218348 |
3,08,873 |
|
4 |
3,00,000 |
0.70842521 |
2,12,528 |
|
TOTAL |
1,075,858 |
||
Initial Investment
The payback period is the number of years taken to recover the initial investments of the project. Here the payback period of the project is 2.50 years given, therefore, we can determine the amount of initial investments of the project
Initial Investment of the Project = $375,000 + $250,000 + [$400,000 x 0.50]
= $375,000 + $250,000 + $200,000
= $825,000
Therefore, the Net Present Value of the Project = Present Value of annual cash inflows – Initial Investments
= $1,075,858 - $825,000
= $250,858
“Hence, the Net Present Value (NPV) of the Project will be $250,858”
The following are the correct statements which indicates the disadvantage of using the regular payback period for capital budgeting decisions
-The payback period does not take into account the time value of money effects of a project’s cash flows.
-The payback period does not take into account the cash flows produced over a project’s entire life.
NOTE
The formula for calculating the Present Value Inflow Factor (PVIF) is [1 / (1 + r)n], where “r” is the Discount Rate/Cost of capital and “n” is the number of years.
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