Question

You are evaluating a project that will cost $500,000, but is expected to produce cash flows of $125,000 per year for 10 years, with the first cash flow in one year. Your cost of capital is 11% and your company’s preferred payback period is three years or less.
1. What is the payback period of this project?
2. Should you take the project if you want to increase the value of the company?

Answer 1

Answer:

1. 4 years

2. No

Explanation:

Payback period calculates the amount of time to recoup the total investment made on a project. It calculates how long the cash flows generated from a project would cover the cost of the project.

The cost of the project is $500,000

Cash flows are $125,000 per year for 10 years.

In the first year, the cost of the project is reduced by $125,000 and becomes $375,000.

In the second year, the cost of the project is reduced by $125,000 and becomes $250,000.

In the third year, the cost of the project is reduced by $125,000 and becomes $125,000.

In the fourth year, the cost of the project is reduced by $125,000 and becomes $0.

The cost of the project is totally recouped in the 4th year. therefore, the payback period is 4 years.

But the company has a preferred payback period of 3 years ,therefore , the firm won't undertake the project because the payback period is more than 3 years.