A firm has an opportunity to invest in a project to install new production equip

Question

A firm has an opportunity to invest in a project to install new production equipment. It will cost them $1,500,000 upfront to purchase and install the equipment. The firms cost of capital is 7%. It is expected that the increased cashflow from the new equipment (above what the current cashflows are) will be as follows: Yr 1: $500,000 Yr 2, $1,000,000 Yr 3 $1,000,000 Yr 4: $600,000 Yr: 5 $500,000 (10 pts) What is the payback period? (10 pts) What is the drawback or limitation of using the payback period to choose projects?

Explanation / Answer

year cash flow cummulative cash flow

0 ( 1,500,000) (1,500,000)

1 500,000 (1,000,000)

2 1,000,000 0

so payback period is 2

limitation of using the payback period to choose projects?

i ignore time value of money

2 dont consider total cash flow

3 favour project having major cash flow in the begining

4 not preferable for calculating for those project where cash outflow happen in later year also

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