Question

7. The NPV and payback period

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	$350,000
Year 2	600,000
Year 3	600,000
Year 4	450,000

If the project’s desired rate of return is 9.00%, the project’s NPV _____ rounded to the nearest whole dollar _____ is     .

Which of the following statements indicates a disadvantage of using the regular, or conventional, payback period for capital budgeting decisions? Check all that apply.

a. The payback period does not take into account the cash flows produced over a project’s entire life.

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

c. The payback period does not take into account the time value of money effects of a project’s cash flows.

Answer 1

Answer:

Payback Period = 2.50 years

Initial Investment = $350,000 + $600,000 + 50% * $600,000
Initial Investment = $1,250,000

Desired Rate of Return = 9.00%

Net Present Value = -$1,250,000 + $350,000/1.09 + $600,000/1.09^2 + $600,000/1.09^3 + $450,000/1.09^4
Net Present Value = $358,210

If the project’s desired rate of return is 9.00%, the project’s NPV is $358,210.

Disadvantage of using the regular, or conventional, payback period for capital budgeting decisions are:
The payback period does not take into account the cash flows produced over a project’s entire life.
The payback period does not take into account the time value of money effects of a project’s cash flows.