Your company is currently considering two investment projects. Each project requires an upfront expenditure of $25 million. You estimate that the cost of capital is 10% and the investments will produce the following after tax cash flows:YearProject AProject B1$5,000,000$20,000,0002$10,000,000$10,000,0003$15,000,000$8,000,0004$20,000,000$6,000,000 a) Calculate the payback period for both projects, then compare to identify which project the firm should undertake.  b) Evaluate the advantages and disadvantages of using the payback method in investment decisions and assess the situations where it should be used.

Question
Asked Nov 17, 2019
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Your company is currently considering two investment projects. Each project requires an upfront expenditure of $25 million. You estimate that the cost of capital is 10% and the investments will produce the following after tax cash flows:

Year

Project A

Project B

1

$5,000,000

$20,000,000

2

$10,000,000

$10,000,000

3

$15,000,000

$8,000,000

4

$20,000,000

$6,000,000

 

  1. a) Calculate the payback period for both projects, then compare to identify which project the firm should undertake. 

 

b) Evaluate the advantages and disadvantages of using the payback method in investment decisions and assess the situations where it should be used.

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Expert Answer

Step 1
  1. a)

Calculation of Payback Period:

The payback period for Project A is 2.67 years and Project B is 1.50 years.

The discounted payback period for Project A is 3.07 years and Project B is 1.83 years.

Excel Spreadsheet:

А
в
с
E
F
G
Н
Cash Flows
Cumulative Cash Flows
Year
2
Project B
Project A
0-$25,000,000-$25,000,000 -$25,000,000-$25,000,000
$5,000,000 $20,000,000 -$20,000,000 -$5,000,000
$10,000,000 $10,000,000 -$10,000,000 S5,000,000
$15,000,000 S8,000,000 $5,000,000
$20,000,000 $6,000,000 $25,000,000 $19,000,000
Payback Period of Project A
Payback Period of Project B
Project A
Project B
3
1
5
2
$13,000,000
6
3
7
4
2.67
9
1.50
10
Cum.Cash Flows
Project A
Cash Flows
11
FVIF
PV of Cash Flows
Year
Project A
0-$25,000,000 -S25,000,000|
$5,000,000 $20,000,000
$10,000,000 $10,000,000
$15,000,000 $8,000,000
$20,000,000 $6,000,000
Discounted Payback Period of Project A
Discounted Payback Period of Project B
Project B
Project B
Project A
-$25,000,000-$25,000,000|-$25,000,000| -$25,000,000|
$4,545,454.55 s18,181,818.18-$20,454,545 -$6,818,182
$8,264,462.81 $8,264,462.81-$12,190,083 $1,446,281
$11,269,722.01 $6,010,518.41
$13,660,269.11$4,098.080.73 $12,739,908 $11,554,880
12
10%
Project B
13
1.0000
14
1
1.1000
15
1.2100
1.3310
-$920,361
$7,456,799
16
3
17
1.4641
4
18
3.07
19
1.83
er
help_outline

Image Transcriptionclose

А в с E F G Н Cash Flows Cumulative Cash Flows Year 2 Project B Project A 0-$25,000,000-$25,000,000 -$25,000,000-$25,000,000 $5,000,000 $20,000,000 -$20,000,000 -$5,000,000 $10,000,000 $10,000,000 -$10,000,000 S5,000,000 $15,000,000 S8,000,000 $5,000,000 $20,000,000 $6,000,000 $25,000,000 $19,000,000 Payback Period of Project A Payback Period of Project B Project A Project B 3 1 5 2 $13,000,000 6 3 7 4 2.67 9 1.50 10 Cum.Cash Flows Project A Cash Flows 11 FVIF PV of Cash Flows Year Project A 0-$25,000,000 -S25,000,000| $5,000,000 $20,000,000 $10,000,000 $10,000,000 $15,000,000 $8,000,000 $20,000,000 $6,000,000 Discounted Payback Period of Project A Discounted Payback Period of Project B Project B Project B Project A -$25,000,000-$25,000,000|-$25,000,000| -$25,000,000| $4,545,454.55 s18,181,818.18-$20,454,545 -$6,818,182 $8,264,462.81 $8,264,462.81-$12,190,083 $1,446,281 $11,269,722.01 $6,010,518.41 $13,660,269.11$4,098.080.73 $12,739,908 $11,554,880 12 10% Project B 13 1.0000 14 1 1.1000 15 1.2100 1.3310 -$920,361 $7,456,799 16 3 17 1.4641 4 18 3.07 19 1.83 er

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Step 2

Excel Workings:

A
в
с
E
G
н
Cash Flows
Cumulative Cash Flows
Year
Project A Project B
-25000000-25000000 B3
5000000
10000000 10000000D4+B5
15000000 8000000 D5+B6
20000000 6000000
Project A
Project B
|-СЗ
=E3+C4
-E4+C5
-E5+C6
-E6+C7
3 0
20000000D3+B4
4 1
5 2
6 3
D6+B7
8 Payback Period of Project A =A5-(D5/B6)
9 Payback Period of Project B=A4-(E4/C5)
7 4
10
11
Cash Flows
FVIF
PV of Cash Flows
Cum. Cash Flows
Year
Project A Project B
-25000000-25000000 (1+10%)^A13 B13/D13 C13/D13E13
5000000
10000000 10000000(1+10%)^A15 | -B15/D15-C15/D15-G14+E15 H14+F15
15000000 8000000(1+10%^A16 =B16/D16 -C16/D16 -G15+E16 -H15+F16
20000000 6000000(1+10%)A17B17/D17-c17/D17-G16+E17 =H16+F17
Discounted Payback Period of Project A
Discounted Payback Period of Project B
Project A Project B Project A Project B
-F13
|20000000(1+10%)^A14 -B14/D14 -C14/D14 -G13+E14- H13+F14
12
@10%
13 0
14 1
15 2
16 3
17 4
=A16-(G16/E17)
=A14-(H14/F15)
18
19
help_outline

Image Transcriptionclose

A в с E G н Cash Flows Cumulative Cash Flows Year Project A Project B -25000000-25000000 B3 5000000 10000000 10000000D4+B5 15000000 8000000 D5+B6 20000000 6000000 Project A Project B |-СЗ =E3+C4 -E4+C5 -E5+C6 -E6+C7 3 0 20000000D3+B4 4 1 5 2 6 3 D6+B7 8 Payback Period of Project A =A5-(D5/B6) 9 Payback Period of Project B=A4-(E4/C5) 7 4 10 11 Cash Flows FVIF PV of Cash Flows Cum. Cash Flows Year Project A Project B -25000000-25000000 (1+10%)^A13 B13/D13 C13/D13E13 5000000 10000000 10000000(1+10%)^A15 | -B15/D15-C15/D15-G14+E15 H14+F15 15000000 8000000(1+10%^A16 =B16/D16 -C16/D16 -G15+E16 -H15+F16 20000000 6000000(1+10%)A17B17/D17-c17/D17-G16+E17 =H16+F17 Discounted Payback Period of Project A Discounted Payback Period of Project B Project A Project B Project A Project B -F13 |20000000(1+10%)^A14 -B14/D14 -C14/D14 -G13+E14- H13+F14 12 @10% 13 0 14 1 15 2 16 3 17 4 =A16-(G16/E17) =A14-(H14/F15) 18 19

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Step 3
  1. b)

The advantages of the payback period is as follows:

  • Highly convenient and easy to use
  • Highly convenient to understand
  • Able to take a decision quickly
  • Gives more preference for liquidity
  • Helpful in case of uncertainty
...

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