Compute the following FCF forecasts(in $s) Year Project A Project B Project C 0
ID: 2773140 • Letter: C
Question
Compute the following FCF forecasts(in $s)
Year Project A Project B Project C
0 (5,000) (5,000) (5,000)
1 2,000 2,000 0
2 2,000 2,000 4,000
3 2,000 2,000 2,000
4 2,000
5 2,000
6 2,000
1. Compute the payback for each project.
2. Compare the payback for Project A with the payback of Project B.
3. Compare the payback for Project B with the payback of Project C.
4. Compare the payback for Project A with the payback of Project C.
5. According to the payback decision rule, which project(s) is acceptable? Why?
6. What disadvantages of using payback as a capital budgeting metric do the above comparisons illustrate?
Explanation / Answer
per the rule, I can answer first four parts only.
1)
Payback period is the period of time a project takes to recover its initial investment.
We need to prepare a cumulative cash flow table to calculate payback period.
Year
Proj A CF
cumulative cash flow A
Proj B CF
cumulative cash flow B
Proj C CF
cumulative cash flow C
0
-5000
-5000
-5000
-5000
-5000
-5000
1
2000
-3000
2000
-3000
0
-5000
2
2000
-1000
2000
-1000
4000
-1000
3
2000
1000
2000
1000
2000
1000
4
2000
3000
5
2000
5000
6
2000
7000
Project A
PBP= last year of negative CF + CF required in the first positive CF year / CF
= 2 + 1000/2000
=2.5 years
Project B
PBP = 2 +1000/2000
= 2.5 years
Project C
PBP = 2 +1000/2000
= 2.5 years
2) Both project A and project B has equal payback period.
3) Both project B and project C has equal payback period.
4) Both project A and project C has equal payback period.
Year
Proj A CF
cumulative cash flow A
Proj B CF
cumulative cash flow B
Proj C CF
cumulative cash flow C
0
-5000
-5000
-5000
-5000
-5000
-5000
1
2000
-3000
2000
-3000
0
-5000
2
2000
-1000
2000
-1000
4000
-1000
3
2000
1000
2000
1000
2000
1000
4
2000
3000
5
2000
5000
6
2000
7000
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