Question

Suppose you are evaluating a project with the cash inflows shown in the following table. Your boss has asked you to calculate the project’s net present value (NPV). You don’t know the project’s initial cost, but you do know the project’s regular, or conventional, payback period is 2.5 years.

The project's annual cash flows are:
Year
Cash Flow
Year 1 $300,000
Year 2 400,000
Year 3 600,000
Year 4 500,000

Answer 1

The payback period does not take the time value of money into account.

The regular payback period is a simple capital budgeting metric that measures the time it takes for a project to recover its initial investment through its generated cash inflows. In this case, the payback period for the project is stated to be 2.50 years. However, a disadvantage of using the regular payback period, as opposed to the discounted payback period, is that it does not consider the time value of money.

The time value of money is a fundamental concept in finance that recognizes the principle that a sum of money today is worth more than the same sum in the future, due to its potential earning capacity. The regular payback period ignores this concept, treating all cash inflows as if they have the same value regardless of when they occur. Consequently, it doesn't factor in the discounting of future cash flows, leading to a potential misrepresentation of the project's true profitability and financial viability.

In contrast, the discounted payback period accounts for the time value of money by applying a discount rate to future cash inflows. This provides a more accurate reflection of the project's economic viability and helps in making more informed capital budgeting decisions.

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