Yonan Inc. is considering Projects S and L, whose cash flows are shown below. Th

Question

Yonan Inc. is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. If the decision is made by choosing the project with the shorter payback, some value may be forgone. How much value will be lost in this instance? Note that under some conditions choosing projects on the basis of the shorter payback will not cause value to be lost. WACC: 10.25% Year 0 1 2 3 4 ------------------------------------------------- CFS $950 $500 $800 $0 $0 CFL $2,100 $400 $800 $800 $1,000

Explanation / Answer

Payback period for S :

cummulative cash flow up to year 1 = -950 +500= -450

Payback period = 1 + (450/500)

                            = 1 + .9

                              = 1.9 years

Paycak period for L=:

Cummulativ ecash flow up to 3 years = -2100 +400+800+800 = -100

payback period = 3 + (100/1000)

                      = 3.1 years

on the basis of payback prohject S shall be selected as it has lower payback period .

However.

Project S :

Present value of cash flow = (.90703 * 500)+(.82270*800)

                                 = 453.52+ 658.16

                                   =1111.68

NPV = 1111.68 -950 = 161.68

Project L:

Present value =(.90703*400)+(.82270*800)+(.74622*800)+(.67684*1000)

                    = 362.81+ 658.16+ 596.98+ 676.84

                      = 2294.79

NPV = 2294.79 -2100 =194.79

Value lost due to selection of lower payback period = 194.79 - 161.68 =33.11

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