What information does the payback period provide? A project's 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 project's liquidity and riskiness. risky than cash flows received in the near-term-which suggests that the payback In general, cash flows expected in the distant future are period can also serve as an indicator of project risk. 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 project's net present value (NPV). You don't know the project's initial cost, but you do know the project's regular, or conventional, payback period is 2.50 years. Year Year 1 Cash Flow $275,000 425,000 450,000 Year 2 Year 3 Year 4 475,000 If the project's weighted average cost of capital (WACC) is 8%, the project's NPV (rounded to the nearest dollar) is: $420,380 $380,344 $400,362 $460,416 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. The payback period does not take the time value of money into account. The payback period does not take the project's entire life into account. The payback period is calculated using net income instead of cash flows. Evaluating projects with unequal lives Your company is considering starting a new project in either Spain or Canada-these projects are mutually exclusive, so your boss has asked you to analyze the projects and then tell her which project will create more value for the company's stockholders. The Spanish project is a six-year project that is expected to produce the following cash flows: Project: Year 0: Year 1: Spanish -$975,000 $350,000 $370,000 $390,000 $320,000 Year 2: Year 3: Year 4: Year 5: $115,000 Year 6: $80,000 The Canadian project is only a three-year project; however, your company plans to repeat the project after three years. The Canadian project is expected to produce the following cash flows: Project: Year 0: Year 1: Canadian -$475,000 $225,000 $235,000 $255,000 Year 2: Year 3: Because the projects have unequal lives, you have decided to use the replacement chain approach to evaluate them. You have determined that the appropriate cost of capital for both projects is 11%. Assuming that the Canadian project's cost and annual cash inflows do not change when the project is repeated in three years and that the cost of capital remains at 11%, answer the following questions: The NPV of the Spanish project is: $259,972 O $247,592 $222,833 $210,453 The NPV of the Canadian project is: $190,660 $172,502 $208,818 $181,581
