11. The NPV and payback period

What information does the payback period provide?

A projects payback period (PB) indicates the number of years required for a project to recover its initial investment using its operating cash flows. As the theoretical soundness of the conventional (undiscounted) PB technique was criticized, the model was modified to incorporate the time value of money-adjusted operating cash flows to create the discounted payback method. While both payback models continue to reflect faulty ranking criteria, they do provide important (useful) information regarding a projects liquidity and riskiness.

In general, the the payback, other things constant, the greater the projects liquidity.

Suppose you are evaluating a project with the expected future cash inflows shown in the following table. Your boss has asked you to calculate the projects net present value (NPV). You dont know the projects initial cost, but you do know the projects regular, or conventional, payback period is 2.50 years.

Year	Cash Flow
Year 1	$300,000
Year 2	400,000
Year 3	500,000
Year 4	450,000

If the projects weighted average cost of capital (WACC) is 9%, the projects NPV (rounded to the nearest dollar) is:

a. $421,802

b. $440,141

c. $366,784

d. $293,427

Which of the following statements indicate a disadvantage of using the regular payback period (not the discounted payback period) for capital budgeting decisions? Check all that apply.

1. The payback period does not take the projects entire life into account.

2. The payback period does not take the time value of money into account.

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