Question

Suppose Acme Manufacturing 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	$350,000
Year 2	$425,000
Year 3	$475,000
Year 4	$425,000

If the project’s weighted average cost of capital (WACC) is 7%, what is its NPV?

$397,786

$437,565

$417,675

$457,454

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 project’s entire life into account.

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

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

Answer 1

Payback period is the time period in which the initial investment is recovered

Hence, Initial cost = 350,000+425,000+475000/2

= 1,012,500

NPV = Present value of cash inflows – present value of cash outflows

= -1,012,500+ 350,000/(1.07) + 425000/(1.07)^2 + 475000/(1.07)^3 + 425000/(1.07)^4

= $397,786.22

i.e. $397,786

The correct one is

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

It uses cash flows and does take into account the time value of money