11. The NPV and payback period What information does the payback period provide?

Question

11. The NPV and payback period What information does the payback period provide? Payback period essentially provides the number of years it would take for a project to recover the initial investment from its operating cash flows. As the model was criticized, the model evolved incorporating time value of money to create the discounted payback method. The models still reflected faulty ranking criteria but they provided important information about liquidity and risk. cash flows expected in the distant future are_more risky than cash flows received in the near-term-which suggests that the payback period can also serve as an indicator of project risk. Suppose Praxis Corporation's CFO is evaluating a project with the following cash inflows. She does not know the project's initial cost; however, she does know that the project's regular payback period is 2.5 years If the project's weighted average cost of capital (WACC) is 796, what is its NPV? Year Cash Flow Year 1 $275,000 Year 2 $400,000 Year 3 $400,000 Year 4 $475,000 O $378,251 $336,223 $420,279 O $441,293

Explanation / Answer

It is given that projects payback period is 2.5 years

Therefore, project is returning its initial capital in 2.5 years

So initial capital = Cash flow of year 1 + Cash flow of year 2 + Cash flow of 6 months between year 2 and 3

We are assuming cash flow in coming evenly in the period therefore Cash flow for 6 moths = 200,000

Initial Capital = 275,000 + 400,000 + 200,000 = 875,000

Cash flows are given for each year

Initial cash flow = -875,000 (negative sign indicates cash outflow)

NPV is sum of present value of cash flows

Present value = cash flow/(1+r)n, where r is required rate of return and n is number of years

NPV = CF0 + CF1/(1+r)1 + CF2/(1+r)2 + CF3/(1+r)3 + CF4/(1+r)4

In this case r is WACC i.e. 7%

NPV = -875000 + 275000/(1.07)1 + 400000/(1.07)2 + 400000/(1.07)3 + 475000/(1.07)4

Solving above equation

NPV = 420279.2

So the answer is option 'c' i.e. $420,279

Question 2 -

Discounted payback method takes only the portion of life that payback initial amount into account and does not take rest of life into account.

It takes time value of money into account as it is disounting cash flows

Discounted payback method uses operating cash flow not net income

Therefore, answer is option A i.e. discounted payback method does not take project;s entire life into account

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