Question
Q4. (25 marks) Alina Smith is considering an investment which will cost her $120,000. The investment...
Q4. (25 marks) Alina Smith is considering an investment which will cost her $120,000. The investment produces no cash flows for the first year. In the second year the cash inflow is $35,000. This inflow will increase to $55,000 and then $75,000 for the following two years before ceasing permanently. Alina requires a 10 % rate of return and has a required discounted payback period of three years. Calculate discounted payback period and comment whether the project should be accepted or not.
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Answer
Payback refers to the time taken by the project to recover its initial investment
We calculate cumulative cash flows for calculating the payback periodCash flows are discounted at 10% .
Year Cash flows Discounted cash flows Cumulative cash flows 0 -120000 -120000 -120000 1 0 0 0 2 35000 28925.62 -91074.4 3 55000 41322.31 -49752.1 4 75000 51226.01 1473.943
As we see the cumulative cash flows become positive between the end of 3rd and 4 th year .
D.P.B = 3 + (49752/51226.01)
= 3+ .97
= 3.97 years
The discounted payback period is greater than 3 years. The PROJECT SHOULD NOT BE ACCEPTED .
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