Practice Questions Week 12
Q1. Payback period
Volkswagen AG (VW) uses a maximum payback period of four years and currently must choose
between two mutually exclusive electric car projects. Project Crozz requires an initial outlay of
€25,000,000; Project Buzz requires an initial outlay of €15,000,000. Using the expected cash
inflows given for each project in the following table, calculate each project’s payback period.
Which project meets VW’s standards?
Solution
The payback period for Project Buzz is 3.75 years. The payback period for Project Crozz is 5.67
years. Project Buzz is acceptable because its payback period is less than VW’s maximum payback
period criterion of 4 years. On the other hand, Project Crozz is not acceptable because its payback
period is more than 4 years.
Q2. Payback comparisons
Soviet Services has a five-year maximum acceptable payback period. The firm is considering
purchasing a new washing machine and must choose between two alternatives. The first machine,
IntelWash, requires an initial investment of $25,000 and generates annual after-tax cash inflows
of $6,500 for each of the next eight years. The second machine, KwikWash, requires an initial
investment of $75,000 and provides an annual cash inflow after taxes of $9,500 for 15 years.
a) Determine the payback period for IntelWash and KwikWash.
b) Comment on the acceptability of the machines, assuming they are independent projects.
c) Which machine should Soviet Services purchase? Why?
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d) Do the machines in this problem illustrate any of the weaknesses of using payback?
Discuss.
Solution
a. IntelWash: $25,000 $6,500 = 3.85 years. KwikWash: $75,000 $9,500 = 7.89 years.
b. The maximum acceptably payback period is 5 years. Only IntelWash has a faster
payback, and Soviet Services should accept only that project.
c. The firm will accept IntelWash because the payback period of 3.85 years is less than the
5-year maximum payback required by Soviet Services.
d. KwikWash has returns for 20 years while IntelWash has only 8 years of returns. The
payback approach does not consider this difference; it ignores all cash inflows beyond
the payback period.
Q3. Discounted payback periods
As a financial analyst for your company, you have been asked to calculate the discounted payback
period for the following projects and recommend whether your firm should accept or reject each
project. Your firm’s cost of capital is 7.8% and your firm uses a maximum allowable payback
period of six years. The cash flows associated with each project are shown in the following table.
a) What is the discounted payback period of each project?
b) Which projects should the company invest in based on the maximum allowable payback
period?
Solution
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Discount each of the project cash inflows using the cost of capital of 7.8%, as shown in the table
below. Then determine the amount of project life necessary to cumulate PV of cash inflows
equal to the project’s initial investment.
Cash
Cummulative Cummulative Cummulative
Year Project X PV of CF PV of CF Project Y PV of CF PV of CF Project Z PV of CF PV of CF
0 -$800,000 -$800,000 -$800,000 -$1,260,000 -$1,260,000 -$1,260,000 -$2,100,000 -$2,100,000 -$2,100,000
1 $50,000 $46,382 -$753,618 $250,000 $231,911 -$1,028,089 $425,000 $394,249 -$1,705,751
2 $100,000 $86,052 -$667,566 $250,000 $215,131 -$812,958 $465,000 $400,143 -$1,305,608
3 $150,000 $119,739 -$547,827 $250,000 $199,565 -$613,394 $489,000 $390,349 -$915,260
4 $200,000 $148,100 -$399,727 $250,000 $185,125 -$428,269 $515,000 $381,357 -$533,902
5 $250,000 $171,730 -$227,997 $250,000 $171,730 -$256,539 $518,000 $355,825 -$178,078
6 $300,000 $191,165 -$36,832 $250,000 $159,304 -$97,234 $535,000 $340,911 $162,834
7 $250,000 $147,778 $50,543 $565,000 $333,977 $496,811
8 $250,000 $137,085 $187,628 $596,000 $326,811 $823,622
9 $615,000 $312,828 $1,136,450
10 $628,000 $296,328 $1,432,778
Payback (years) Never fully paid back 6.66 5.52
Project X never fully recoups (pays back) the investment of $800,000.
Project Y has a payback period of: 6+ 97,234 ÷ 147,778 = 6 + 0.657973 = 6.66 years.
Project Z has a payback period of: 5 + 178,078 ÷ 340,911 = 5 + 0.522359 = 5.52 years.
b. Based on the maximum acceptable payback period of 6 years set by the firm, the firm should
only accept project Z.
Q4. Net Present Value (NPV)
Axis Corp. is studying two mutually exclusive projects. Project Kelvin involves an overhaul of the
existing system; it will cost $52,500 and generate cash inflows of $24,500 per year for the next
three years. Project Thompson replaces the existing system; it will cost $265,000 and generate
cash inflows of $61,000 per year for six years. Using an 8.75% cost of capital, calculate each
project’s NPV, and make a recommendation based on your findings.
Solution
Project Kelvin
Project cost (year 0) = $52,500
Cash inflows (years 1-3) = $24,500 per year; cost of capital (discount rate) = 8.75%
Present value = $62,294.08.
NPV = $62,294.08 – $52,500 = $9,794.08
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Project Thompson
Project cost (year 0) = $265,000
Cash inflows (years 1-6) = $61,000 per year; cost of capital (discount rate) = 8.75%
Present value = $275,692.73.
NPV = $275,692.73 – $265,000 = $10,692.73
Axis should undertake project Thompson because it has the higher NPV (and hence will add more to
shareholder wealth).
Q5. NPV for varying costs of capital Empire
Hotel is considering acquiring new flatpanel displays to replace the antiquated computer terminals
at the registration desk. The new computer displays require an initial investment of $235,000 and
will generate after-tax cash inflows of $65,000 per year for five years. For each of the costs of
capital listed, (1) calculate the net present value (NPV), (2) indicate whether to accept or reject the
machine, and (3) explain your decision.
a) The cost of capital is 8%.
b) The cost of capital is 10%.
c) The cost of capital is 15%.
Solution
NPV = Present value of cash inflows from project − Initial investment. All projects have 5-year lives,
an initial cost of $235,000, and annual cash inflows of $65,000.
Find the NPV under a series of different discount rates.
a. Cost of capital = 8%, so present value of cash inflows = $259,526.15.
NPV = $259,526.15 – $235,000 = $24,526.15. The NPV is positive, so the project
should be accepted. Specifically, the acceptance will raise shareholder wealth by
$24,526.15 (the NPV amount).
b. Cost of capital = 10%, so the present value of cash inflows = $246,401.14. NPV =
$246,401.14 – $235,000 = $11,401.14. The project should be accepted because the
NPV is positive. Specifically, the acceptance will raise shareholder wealth by
$11,401.14 (the NPV amount).
c. Cost of capital = 15%, so the present value of cash inflows = $217,890.08. NPV =
$217,890.08 – $235,000 = – $17,109.92. The project should be rejected because the
NPV is negative. Specifically, its acceptance will reduce shareholder wealth by
$17,109.92 (the NPV amount).
Q6. Long-term investment decision, payback method Francesco Giovanni’s business partner,
Pepino, has proposed that they invest in a coffee shop. This investment costs €90,000 today and
promises to pay €22,000, €25,000, €25,000, €20,000, and €18,000 over the next five years.
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Alternatively, Pepino suggests they can invest €90,000 in a restaurant, which promises to pay
€15,000, €15,000, €15,000, €35,000, and €40,000 over the next five years.
a) How long will it take for Francesco and Pepino to recoup their initial investment in the
coffee shop?
b) How long will it take them to recoup their initial investment in the restaurant?
c) Using the payback period, which project should Francesco and Pepino choose?
d) Do you see any problems with their choice?
Solution
a. and b.
Coffee Shop Restaurant
Annual Cumulative Annual Cumulative
Year Cash Flow Cash Flow Cash Flow Cash Flow
0 $90,000 $90,000 $90,000 $90,000
1 22,000 68,000 15,000 75,000
2 25,000 43,000 15,000 60,000
3 25,000 18,000 15,000 45,000
4 20,000 35,000 10,000
5 18,000 40,000
Project Cost $110,000 $120,000
Payback Period 3 + 18,000/20,000 = 3.9 years 4 + 10,000/40,000 = 4.25 years
c. The payback method would select the coffee shop because it’s payback period of 3.9
years is lower than the restaurant’s payback period of 4.25 years.
d. One shortcoming of the payback method is that it disregards expected future cash flows
as in the case of the restaurant.
