P2E.3 Payback & Discounted Payback

Question 1

Payback Period

Answer 1

Number of years to recover the initial investment based on after-tax net cash inflows.

= Initial investment / After-tax net cash flows
= Final Period of Negative Cumulative After-tax Cash Flow + (Remaining Uncovered Cash Flows / After-tax Cash Inflows During Final Year)

Question 2

Discounted Payback Period

Answer 2

Number of years to recover the initial investment based on the discounted after-tax net cash inflows.

= Initial investment / Discounted after-tax net cash inflows

Question 3

Payback Period Advantages & Disadvantages

Answer 3

Advantages
1. Simple and easy to calculate

Disadvantages

1. Doesn’t consider time value of money
2. Doesn’t evaluate whether an investment increases the firm’s value
3. Disregards the cash inflows beyond the payback period.

Question 4

Discounted Payback Advantages & Disadvantages

Answer 4

Advantages
1. Considers time value of money

Disadvantages

1. Calculation is more involved than payback period
2. Doesn’t evaluate whether an investment increases firms value
3. Disregards the cash flows beyond the discounted payback period.