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Why the payback method is often considered inferior to discounted cash flow in capital
investment appraisal?
A. It does not take account of the time value of money
B. It does not calculate how long it will take to recoup the money invested
C. It is more difficult to calculate
D. It only takes into account the future income of a project
(Ans.: A)
Explanation:
NPV Method
Under the net present value method, a business estimates all the cash flows, both positive (revenue)
and negative (costs), of pursuing a project, now and in the future. It then adjusts, or "discounts," the
value of future cash flows to reflect what they're worth in the present day. It makes this adjustment
using a "discount rate" that takes into account inflation, the risk of the project and the cost of capital --
either interest paid on borrowed money or interest not earned on money spent to pursue the project.
Finally, it adds up the present values of all the positive and negative cash flows to arrive at the net
present value, or NPV. If the NPV is positive, the project is worth pursuing; if it's negative, the project
should be rejected. When deciding between projects, choose the one with the higher NPV.
Payback Period
Under the payback period method, a company estimates how much it will cost to launch the project
and how much money the project will generate once it's up and running. It then calculates how long it
will take the project to "break even," or generate enough money to cover the startup costs. Companies
using the payback period method typically choose a time horizon -- for example, 2, 5 or 10 years. If a
project can "pay back" the startup costs within that time horizon, it's worth doing; if it can't, the
project will be rejected. When deciding between projects, choose the one with the shorter payback
period.
The payback period method has some key weakness that the NPV method does not. One is that the
payback method doesn't take into account inflation and the cost of capital. It essentially equates $1
today with $1 at some point in the future, when in fact the purchasing power of money declines over
time. Another is that the payback method ignores all cash flows beyond the time horizon -- and those
cash flows may be substantial. Big moneymakers, after all, sometimes take a while to get going. On
the other hand, the big drawback of the NPV method lies in its assumptions. If you don't get your
estimate of the discount rate correct, your calculation will be off -- and you won't know it until the
project turns into a big money-loser.
Combining Methods
Many businesses use a combination of methods when making capital budgeting decisions. A company
could use the payback period method to narrow down its options, then apply the NPV method to
identify the best of the remaining projects. Or it could use the NPV method to separate the "winners"
from the "losers" among possible projects, then look at payback periods to see which projects return
their costs more quickly.
2. Guddu is considering the purchase of an asset for Rs.120,000. This asset will generate the
following cash flows:
Year Rs.
Year 1 15,000
Year 2 25,000
Year 3 40,000
Year 4 40,000
Year 5 35,000
Year 6 30,000
Using a discount rate of 20% the discounted payback period would be:
A. 6 years
B. 4 years
C. The investment does not pay back
D. 5 years
(Ans.: C)
Explanation: The discounted payback can be calculated in the following way:
Cumulative Cash Flow
Year Cash Flow (Rs.) Discount Factor Discounted Cash Flow (Rs.)
(Rs.)
0 (120,000) 1.000 (120,000) (120,000)
1 15,000 0.8333 12,495 (107,505)
2 25,000 0.694 17,350 (90,155)
3 40,000 0.579 23,160 (66,995)
4 40,000 0.482 19,280 (47,715)
5 35,000 0.402 14,070 (33,645)
6 30,000 0.322 9,660 (23,985)
The project does not pay back the original cost of the asset.
3. A project that has been tested for its feasibility has already incurred market research costs of
Rs.50,000. The actual cost of the asset is Rs.100,000 and the project is expected to yield the
following returns:
Year 1 Rs. 90,000
Year 2 Rs. 80,000
Year 3 Rs.70,000
If the discount rate is 12% the NPV of the project will be:
A. Rs.140,000
B. Rs.44,000
C. Rs.94,000
D. Rs.294,000
(Ans.: C)
Explanation: The market research expenditure that has already been incurred is a sunk cost and is
irrelevant in the decision to accept or reject the project. The appraisal for the project is:
Year Cash Flow (Rs.) Discount Rate Discounted Cash Flow (Rs.)
Year 0 (100,000) 1.000 (100,000)
Year 1 Rs. 90,000 0.893 80,370
Year 2 Rs. 80,000 0.793 63,440
Year 3 Rs.70,000 0.712 49,840
93,650
Table below shows the information related to a project that involves the merger of two marketing
firms (in days).
8. If there is an option to delay one activity without delaying the entire merge project, which
activity would you delay?
A. Activity A
B. Activity B
C. Activity A and Activity C
D. None of these
(Ans.: C)
Activity Earliest Start Latest Start Earliest Finish Latest Finish Slack
Start 0 0 0 0 0
A 0 13 10 23 13
B 0 0 15 15 0
C 10 23 15 28 13
D 15 15 27 27 0
E 27 28 41 42 1
F 15 19 23 27 4
G 27 27 42 42 0
H 41 47 51 57 6
I 42 42 48 48 0
J 48 48 57 57 0
Finish 57 57 57 57 0
Consider the network information shown in the previous problem (Problems 7 - 9) and assume that
the duration of some activities is not known with certainty. The estimates of these activities are shown
below, assuming that the duration for the other activities remains unchanged.
Activity Optimistic Most Likely Pessimistic
A 8 10 12
C 3 5 7
D 10 12 14
G 13 15 17
H 8 10 12
12. What is the probability that the project will be completed in 60 days or more?
A. 0.10%
B. 0.20%
C. 0.15%
D. 0.05%
(Ans.: A)
13. What is the probability that the project will be completed in 55 days or more?
A. 0.0100
B. 0.0212
C. 0.0150
D. 0.0050
(Ans.: B)
14. If the company wants a 96% probability of completing the project on time, state the latest
time each activity should have started and completed.
A. 57 days
B. 58.65 days
C. 59.18 days
D. 60 days
(Ans.: B)
Explanation: The mean and variance for activities for which the duration is not known with certainty:
Activity a m b 𝑡𝑒 𝜎2
A 8 10 12 10 0.44
C 3 5 7 5 0.44
D 10 12 14 12 0.44
G 13 15 17 15 0.44
H 8 10 12 10 0.44
The probability that the project will be completed in 55 days or less: 𝑃(𝑋 ≤ 50) = 𝑃(𝑋 ≤ 𝑧), where
55−57
𝑧= = −2.13. Therefore, 𝑃(𝑋 ≥ −2.13) = 0.5 − 0.4788 = 0.0212 or 2.12 %.
√0.88
𝑍0.96 = 1.76, the project completion time 𝑋 = 57 + 1.76 × 0.938 = 58.65 days. Therefore to meet
this completion time, the latest start and finish times for each activity should be as follows:
Activity Latest Start Latest Finish
Start 1.65 1.65
A 14.65 24.65
B 1.65 16.65
C 24.65 29.65
D 16.65 28.65
E 29.65 43.65
F 20.65 28.65
G 28.65 43.65
H 48.65 58.65
I 43.65 49.65
J 49.65 58.65
Finish 58.65 58.65
15. A company has to make a choice between two projects, because the available resources in
money and kind are not sufficient to run both at the same time. Each project would take 9
months and would cost $250,000. The first project is a process optimization which would
result in a cost reduction of $120,000 per year. This benefit would be achieved immediately
after the end of the project. The second project would be the development of a new product
which could produce the following net profits after the end of the project:
YEAR PROFIT
1st year $15,000
2nd Year $125,000
rd
3 Year $220,000
Assumed a discount rate of 5% per year. Looking at the present values of the benefits of these
projects in the first 3 years, what is true?
A. Both projects are equally attractive.
B. The first project is more attractive by approx. 7%.
C. The second project is more attractive by approx. 5%.
D. The first project is more attractive by approx. 3%.
(Ans.: D)
PV=FV/(1+R)^Y
Project 1
Yr1 $ 120,000/(1+0.05)^1 = $ 114,286
Yr2 $ 120,000/(1+0.05)^2 = $ 108,844
Yr2 $ 120,000/(1+0.05)^3 = $ 103,661
Total $ 326,791
Project 2
Yr1 $ 15,000/(1+0.05)^1 = $ 14,286
Yr2 $ 125,000/(1+0.05)^2 = $ 113,379
Yr2 $ 220,000/(1+0.05)^3 = $ 190,044
Total $ 317,709
Conclusion: Project 1 has better return by 3% (326,791/317,709 = 1.0285). Benefit Cost Ration (
BCR ) = 326791 / 250000 = 1.30. This means Payback is 1.3 times of the cost.
16. The objective of project crashing is to:
A) Reduce the project duration and revise the network critical path and completion times
when the schedule falls hopelessly behind
B) Minimize the cost of crashing
C) Reduce indirect costs such as interest on investments
D) More than one statement above is true
(Ans.: D)
17. Shared slack in an activity network is defined as:
A) The amount of time an activity can be delayed without delaying the entire project.
B) The amount of slack that an activity has in common with another activity.
C) The amount of unused resources for an activity.
D) The amount by which a time estimate can be in error without affecting the critical path
computations.
(Ans.: B)
18. Based on the list of activities below which of the following can be said?
Activity IP
A -
B -
C A, B
D A, C
Indirect cost for a project is $12 000 per week for as long as the project lasts. The project manager has
supplied the cost and time information and precedence network diagram shown in Figure and the table
given below:
Activity Crashing Potential (Weeks) Cost per Week to Crash
A 3 $11,000
B 3 $3,000 (1st Week), $4,000 (2nd Week)
C 2 $6,000
D 1 $1,000
E 3 $6,000
F 1 $2,000
21. What is the total duration of the project after all activities are crashed?
A. 23 Weeks
B. 22 Weeks
C. 21 Weeks
D. 20 Weeks
(Ans.: D)
22. What is the total cost of the project involved after all activities are crashed?
A. Rs. 276,000
B. Rs. 271,000
C. Rs. 273,000
D. Rs. 279,000
(Ans.: A)