6-4 (Problem 14) You are considering making a movie. The movie is expected to co

Question

6-4 (Problem 14) You are considering making a movie. The movie is expected to cost $10

Million upfront and take a year to make. After that, it is expected to make $5 million in the

year it is released and $2 million for the following four years. What is the payback period of

this investment? If your inquire a payback period of two years, will you make the movie? Does

the movie have positive NPV if the cost of capital is 10%?

Response:

What is the payback period of this investment?

                (Year 1 = $5 mil) + (Year 2 = $2 mil) + (Year 3 = $2 mil) + (6 months = $1 mil) = $10 mil

                Payback = 3.5 years

If you require a payback period of two years, will you make the movie?

                (Year 1 = $5 mil) + (Year 2 = $2 mil) = $7 mil

A two year payback will leave you short by $3mil so it would not be recommended to make the movie.

Does the movie have positiveNPV if the cost of capital is 10%?

                -$10mil + ($5mil/1.1) + ($2mil/1.12) + ($2mil/1.13) + ($2mil/1.14) + ($2mil/1.15) = $309,000

Explanation / Answer

Payback Period:    Amount oftime required for a project to generate cash flows that coverthe initial investment outlay.

           Therefore, in 3.5 years we will recover the $10,000,000initial investment that we put down. That’s why this term iscalled “Pay back”, it will take this investment 3.5years to pay us back.

NPV Rule:     Theacceptance rule using the NPV method is to accept the investmentproject if its net present value is positive (NPV>0) and toreject it if the net present value is negative (NPV<0).

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