Question

7) A company uses the payback method to evaluate capital budgeting projects. It is currently considering projects A, B and C.

Project A Project B Project C

Initial cost (cash outflow) $10,000 $10,000 $10,000

Cash inflows:

1^{st}
year $ 1,000 $9,000 $ 5,000

2^{nd} year
$9,000 $1,000 $5,000

3^{rd} year $15,000
- 0
- $35,000

a) Find the payback period for each of the above capital budgeting projects. Label the payback period for each project so I can see which payback period goes with which project.

b) What two major weaknesses of the payback method are illustrated by this problem? Explain each.

Answer #1

Let us find the cumulative cash flows for each project. Payback period is the period when the cumulative cash flows become positive.

Project A | ||

Year | Cash Flow | Cumulative |

0 | -10000 | -10000 |

1 | 1000 | -9000 |

2 | 9000 | 0 |

3 | 15000 | 15000 |

Project B | ||

Year | Cash Flow | Cumulative |

0 | -10000 | -10000 |

1 | 9000 | -1000 |

2 | 1000 | 0 |

3 | 0 | 0 |

Project C | ||

Year | Cash Flow | Cumulative |

0 | -10000 | -10000 |

1 | 5000 | -5000 |

2 | 5000 | 0 |

3 | 35000 | 35000 |

Payback for Project A = 2 years

Payback for Project B = 2 years

Payback for Project C = 2 years

(b) The payback period does not take into account the (i) the cash flows of the projects (ii) time period of the cash flows of the project (discounting effect)

This can lead to incorrect decision, since a project with lower payback can have lower NPV as well, leading to incorrect project selection

5 Macy's uses the Payback Period method for evaluating its
projects. The Payback Period cut-off rule is 3 years. Macys is
considering the following project: Cash Flow for Year Project A 0
-$75,000 1 $33,000 2 $36,000 3 $19,000 4 $9,000 Required: a) Should
macys accept or reject Project A why or why not?

Given the following cash flows, for the two independent
projects A and B, calculate
Payback
Period
Accounting rate of
return
Net Present
Value
Profitability
index
And recommend acceptance or rejection of projects considering
individual techniques of capital budgeting. A rate of 10 % has been
selected for the NPV analysis.
Project A
Project B
Initial outlay
$50,000
$100,000
Cash inflows
Year 1
$10,000
$ 25,000
Year 2
15,000
25,000
Year 3
20,000
25,000
Year 4
25,000
25,000...

What is the payback period on each of the following
projects?
Given that you wish to use the payback rule with a cutoff
period of three years, which projects would you accept?
Cash Flows, $
Project
C0
C1
C2
C3
C4
A
-10,000
+1,000
+1,000
+2,000
+6,000
B
-5,000
0
+1,000
+1,500
+3,000
C
-2,000
+2,000
+4,000
+1,000
+5,000

2Assume that you are a new analyst hired to
evaluate the capital budgeting projects of the company which is
considering investing in two CPEC projects, “Expansion Zone North”
and “Expansion Zone East”. The initial cost of each project is Rs.
10,000. Company discount all projects based on WACC. Further, all
the projects are equally risky projects and the company uses only
debt and common equity for financing these projects. It can borrow
unlimited amounts at an interest rate of rd...

You are a financial analyst for Hittle Company. The director of
capital budgeting has asked you to analyze two proposed capital
investments, Projects X and Y. Each project has a cost of $10,000,
and the cost of capital for each project is 10 percent. The payback
cutoff period is 3 years. The projects’ expected net cash flows are
as follows:
Expected Net Cash Flows
Year
Project X
0 ($10,000)
1 6,500
2 3,000
3 3,000
4 1,000
Project Y
($10,000)...

The CEO just announces that all capital budgeting projects must
meet a payback threshold of four years. What is the project’s
payback period? Will you accept the project? Comment

Payback period
Smith Inc. is considering a capital expenditure that requires an
initial investment of $35,000 and returns after-tax cash inflows of
$6,000 per year for 8 years. The firm has a maximum acceptable
payback period of 6 years. a. Determine the payback period for this
project. b. Should the company accept or reject the project?
Why?

Pay Back Method
What is the payback period for the
following project?
Year
Inflow/(Outflow)
($38,000)
$ 8,000
$ 9,000
$ 12,000
$ 7,000
$ 8,000
$ 5,000
$ 3,000

Please Answer Both! Thank you
23. A significant flaw in the payback method of capital
budgeting is that____________
Question 23 options:
it is calculated using arithmetic average instead of weighted
moving average.
it assumes future cash flows are reinvested at the IRR.
it ignores cash flows following the payback period.
it only calculates present values prior to comparing them to
investment amount.
24. A project will cost $20,000 in total investment. The cash
flows are as follows: Year 1: $5,000?...

Pay Back Method
What is the payback period for the following project?
Year Inflow/(Outflow)
($38,000)
$ 8,000
$ 9,000
$ 12,000
$ 7,000
$ 8,000
$ 5,000
7 $ 3,000

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