Cash flow | |Year | |Year |Cash flows |Cumulative CF |Year/fraction | | |1 |382875 |382875 |1 | | |2 |579500 |962375 |1 | | |3 |579500 |1541875 |1 | | |4 |579500 |158125/579500 |0. 7 | | |5 |579500 | |3. 27 |years | The payback period has been calculated by finding the cumulative cash flow by adding each year cash flow to arrive at the figure of initial investment of $1700000. Till year thee the amount is 1541875, which is short by 158125 which will be covered in the fourth year, but not complete year 4, therefore 158125 has been divided by the total cash flow of the year, which gives a fraction of 0. 27, it means that total recovery period is 3. 7 years. |Net Present Value | |Year |Cash flows |PVIF |PV | |1 |382875 |0. 9091 |348068 | |2 |579500 |0. 8264 |478926 | |3 |579500 |0. 7513 |435387 | |4 |579500 |0. 6830 |395806 | |5 |579500 |0. 6209 |359824 | |6 |474500 |0. 645 |267843 | |7 |474500 |0. 5132 |243494 | |8 |674500 |0. 4665 |314659 | | | |PV of inflows |2844007 | | | |less Outflow |-1700000 | | | |NPV |1144007 | The present value of all years cash flow has been calculated by using discount factor of 10% and using the formula for present value interest factor which is 1/1+r^n.
Then the present values of all years have been added and then the initial investment has been deducted to arrive at the NPV, which is positive. The working capital of $200000 has been added at the end of year 8 as it will be recovered in the last year. The project should be accepted as the NPV is positive by big margin, even if the payback period is slightly higher than the company target period of 3 years, it should be accepted, as the final decision is to be based on NPV, not on the basis of payback period.
As the payback period does not consider the cash flow after the payback period. Any investment in land and building would have lowered the NPV by that amount, if suppose the investment would be $300000, the NPV would be 1144007-300000 = 844007, still the project is acceptable. Any amount of investment in land and building for more than 1144007 would have changed the decision as the NPV would become zero or negative.
