Question

11. The NPV and payback period

What information does the payback period provide?

A project’s payback period (PB) indicates the number of years required for a project to recover its initial investment using its operating cash flows. As the theoretical soundness of the conventional (undiscounted) PB technique was criticized, the model was modified to incorporate the time value of money-adjusted operating cash flows to create the discounted payback method. While both payback models continue to reflect faulty ranking criteria, they do provide important (useful) information regarding a project’s liquidity and riskiness.

In general, the ??????(LONGER?SHORTER the payback, other things constant, the greater the project’s liquidity.

Suppose you are evaluating a project with the expected future 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.

Year	Cash Flow
Year 1	$300,000
Year 2	475,000
Year 3	475,000
Year 4	500,000

If the project’s weighted average cost of capital (WACC) is 10%, the project’s NPV (rounded to the nearest dollar) is:

$368,730

$333,612

$386,288

$351,171

Which of the following statements indicate a disadvantage of using the regular payback period (not the discounted payback period) for capital budgeting decisions? Check all that apply.

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

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

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

Answer 1