Page 42 - AFM Integrated Workbook STUDENT S18-J19

Chapter 2

Illustration 1

Konta Co is evaluating a new investment project.

The forecast free cash flows are:

$000 T 0 T 1 T 2 T 3 T 4 T 5

FCF (3,500) 1,200 1,150 1,450 1,300 1,000

The company’s cost of capital is 10%.

Required:

Calculate the project’s payback period and discounted payback period.

Solution

The project’s payback period (assuming that cash flows arise at the end of
each year) is three years (because by T 3 the total cash inflows amount to
$3,800,000 so the initial investment of $3,500,000 has been paid back).

The discounted payback period can be calculated by discounting the cash
inflows before accumulating them, as follows:

Time Discounted cash flow Cumulative position

(3,500) (3,500)
T 0

T 1 1,200 × 0.909 =1,091 (2,409)

T 2 1,150 × 0.826 = 950 (1,459)

T 3 1,450 × 0.751 = 1,089 (370)

T 4 1,300 × 0.683 = 888 518

The project’s discounted payback period (assuming that cash flows arise at
the end of each year) is four years.

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