Answer to Question #176793 in Financial Math for Svhdw

Question

TK Company wants to invest in one of two investment projects, A and B.

The cost of investment project A is 20.000.000 TL.

The cost of investment project B is 30.000.000 TL Net cash flows to be provided by the projects are as follows:

Year Project A Net Net Cash Flows (TL)

1. 5.000.000

2. 6.000.000

3. 7.000.000

4. 8.000.000

5. 9.000.000

Year. Project B Net Cash Flows (TL)

1. 7.000.000

2. 8.000.000

3. 9.000.000

4. 24.000.000

5. 21.000.000

1. Calculate the payback period of both projects?

2. Explain which project should be preferred and why?

3. What are the shortcomings of the payback period method?

4. What is the criterion to be taken as basis when deciding on the payback period?

Is the payback period method acceptable as the main criterion for project acceptance?

5. Why is the NPV always accepted as a primary decision criterion? 

Answer 1

1

Payback period for project A

Payback Period$=A + \frac{B}{C}$

Where,

A is the last period number with a negative cumulative cash flow;

B is the absolute value (i.e. value without negative sign) of cumulative net cash flow at the end of the period A; and

C is the total cash inflow during the period following period A

$=3+ \frac{2}{8}=3.25years$

Payback period for project B

$Payback Period =A + \frac{B}{C}$

Where,

A is the last period number with a negative cumulative cash flow;

B is the absolute value (i.e. value without negative sign) of cumulative net cash flow at the end of the period A; and

C is the total cash inflow during the period following period A

$= 3+ \frac{6}{24}=3.25 years$

2.

since the two project have the same payback period. In this instance, the payback method does not provide a clear determination as to which project to select.

3.

Shortcomings of the payback method

Ignores the time value of money: If wo projects have the same payback period and one project generates more cash flow in the early years whereas the other project has higher cash flows in the later years.

Neglects cash flows received after payback period: For some projects, the largest cash flows may not occur until after the payback period has ended. These projects could have higher returns on investment and may be preferable to projects that have shorter payback times.

Ignores a project's profitability: Just because a project has a short payback period does not mean that it is profitable. If the cash flows end at the payback period or are drastically reduced, a project might never return a profit and therefore, it would be an unwise investment.

Does not consider a project's return on investment: Some companies require capital investments to exceed a certain hurdle of rate of return; otherwise the project is declined. The payback method does not consider a project's rate of return.

4.

The payback method is based on the criterion that the project with the shorter payback period is selected

However it is not acceptable as the main criterion for project acceptance because some projects could have shorter payback period but may not be profitable compared to other projects with longer payback period.

5.

In accordance with the net present value theory, it is logical that investing in something that has a net present value greater than zero should increase a company's earnings