Question

You are evaluating a project that will cost $462,000, but is expected to produce cash flows of $120,000 per year for 10 years, with the first cash flow in one year. Your cost of capital is 10.8% and your company's preferred payback period is three years or less.

a. What is the payback period of this project?
b. Should you take the project if you want to increase the value of the company?

Answer 1

a. The payback period of this project is approximately 3.85 years. b. The decision to take the project should consider other investment evaluation methods such as NPV or IRR.

Step-by-step explanation:

a. The payback period of a project is the length of time it takes to recover the initial investment. To calculate the payback period, you divide the initial investment by the annual cash flows. In this case, the initial investment is $462,000 and the annual cash flows are $120,000. The payback period is calculated as:

Payback Period = Initial Investment / Annual Cash Flows

Payback Period = $462,000 / $120,000 = 3.85 years

So, the payback period of this project is approximately 3.85 years.

b. The decision to take the project should not be solely based on the payback period. While the payback period gives an indication of how quickly the initial investment will be recovered, it does not consider the time value of money or the profitability of the project. To determine whether you should take the project and increase the value of the company, you should consider other investment evaluation methods such as net present value (NPV) or internal rate of return (IRR).