CONNECT PLUS-FINANCIAL & MANAGERIAL AC
CONNECT PLUS-FINANCIAL & MANAGERIAL AC
7th Edition
ISBN: 2810020507384
Author: Wild
Publisher: MCG
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Chapter 24, Problem 5BTN
To determine

Net Present Value (NPV) Method:

Net present value method is a measure to compare the current worth of cash inflows and current worth of cash outflows to determine the profitability of an investment decision.

Payback Period:

Payback period refers to the time period needed to recover the amount invested in project from the cash inflow received from it.

Formula to calculate payback period,

    Payback period= Total investment Amount invested

Cash Flow:

Cash flow is as statement of sum total of income received also referred as cash inflows and expense incurred referred as cash outflow for a particular period of time.

To compute: Payback period and net present value (NPV) of the investment.

Expert Solution & Answer
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Explanation of Solution

Payback Period

Given below is the table for the computation of payback period:

Payback period
Year Net cash flows ($) Cumulative net cash flows ($)
0 ( 15,000 ) ( 15,000 )
1 1,000 ( 14,000 )
2 2,000 ( 12,000 )
3 3,000 ( 9,000 )
4 6,000 ( 3,000 )
5 7,000 4,000
Table(1)
  • As per above table, the cash flow is positive after 4th year, hence it can be said that cash flow is received after 4th year.
  • In order to find the actual payback period, divide the negative cumulative net cash flows of 4th year by the net cash flow of the 5th year, then add the given duration to the 4th year.
  • Formula to calculate total payback period,

      Total payback period=( 4 years+ Negative cumulative net cash flows of 4 th year Net cash flow of the 5 th year )

    Substitute $3,000 for negative cumulative cash flows of 4th year and $7,000 for net cash flow of the 5th year.

      Total payback period=( 4 years+ $3,000 $7,000 ) =4.4 years

    Hence, payback period of investment of $15,000 is 4.4 years.

    Net Present Value (NPV)

    Given below is the table for the computation of Net Present Value (NPV).

    Net Present Value
    Year Cash flows ($) Present value of 1 at 10% Present value of net cash flows ($)
    1 1,000 0.9091 9,09.10
    2 2,000 0.8264 1,652.80
    3 3,000 0.7513 2,253.90
    4 6,000 0.6209 4,098.00
    5 7,000 4,346.30
    Total cash flows 13,260.10
    Invested amount 15,000 ( 15,000 )
    Net present value ( 1,739.90 )
    Table(2)

    Hence, NPV for investment is $(1,739.90) as the total flows did not recover the invested amount of $15,000.

    Payback Period

    Given below is the table for the computation of payback period according to the website detail:

    Payback period
    Year Net cash flows ($) Cumulative net cash flows ($)
    0 ( 15,000 ) ( 15,000 )
    1 7,000 ( 8,000 )
    2 6,000 ( 2,000 )
    3 3,000 1,000
    4 2,000 3,000
    5 1,000 4,000
    Table(3)
    • As per above table, the cash flow is positive after 2nd year, hence it can be said that cash flow is received after 2nd year.
    • In order to find the actual payback period, divide the negative cumulative net cash flows of 2nd year by the net cash flow of the 3rd year, then add the given duration to the 2nd year.

    Formula to calculate total payback period,

      Total payback period=( ( 2 years ) +( Negative cumulative net cash flows of 2 nd  year Net cash flow of the 3 rd year ) )

    Substitute $2,000 for negative cumulative cash flows of 2nd year and $7,000 for net cash flow of the 3rd year.

      Total payback period=( 2 years+ $2,000 $3,000 ) =2.66 years

    Hence, payback period of investment of $15,000 is 2.66 years.

    Net Present Value (NPV)

    Given below is the table for the computation of Net Present Value (NPV).

    Net Present Value
    Year Cash flows ($) Present value of 1 at 10% Present value of net cash flows ($)
    1 7,000 0.9091 6,363.70
    2 6,000 0.8264 4,958.40
    3 3,000 0.7513 2,253.90
    4 2,000 0.6830 1,366.00
    5 1,000 0.6209 620.90
    Total cash flows 15,562.90
    Invested amount 15,000 ( 15,000 )
    Net present value 562.90
    Table(4)

    Hence, NPV for investment is $562.90.

    Hence, the project as per book sum has higher payback period and negative NPV as compared to website sum. This will result in rejection of the project.

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    Chapter 24 Solutions

    CONNECT PLUS-FINANCIAL & MANAGERIAL AC

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