Payback Period, Net Present Value, and Internal Rate of Return
BASICS OF CAPITAL BUDGETING
Pearland Medical Center is considering two proposed capital investment opportunities, Project A and Project B. Each project requires a net investment of $100,000. The cost of capital for each project is 12 percent. The projects' expected cash revenues are:
Year Project A Project B
0 ($100,000) ($100,000)
1 $62,500 $32,625
2 $30,000 $32,625
3 $28,000 $32,625
4 $10,000 $32,625
Calculate each project's payback period, net present value, and internal rate of return. Explain which project is financially acceptable.
Avery, Flaherty, and Rhee (2011) noted that when choosing a capital budgeting decision tool, academics recommend NPV as the primary approach followed by IRR. The payback period method is also presented but is treated as a decision aid.
If the payback period method is inferior relative to NPV, why are firms still using it as a primary decision tool? Based upon what you have read in this article and your other research, do you agree with the statement that payback period has little practical relevance? Explain your answer.
Student's Name
Institutional Affiliation
Healthcare Finance
Net Present Value
It is the sum of present value of all cash flows that a project expects during its life cycle.
Years
Project A
NPV
Project B
NPV
0
0
(100,000)
0
(100,000)
1
62,500
55,803.57
32,625
29,129.46
2
30,000
23,915.82
32,625
26,008.45
3
28,000
19,930.24
32,625
23,222.29
4
10,000
7,117.94
32,625
20,734.03
Total
106,767.57
99,094.23
NPV
6,767.57
-905.77
Payback Period
Is the period of time that a project requires to recover the amount of its initial investment
Payback period= Years+(A/B) where A is the amount remaining for the project to break even and B is the amount to be paid in that year.
Project A
Year
Cumulative Amount
1
62500
2
90,500
3
118,500
4
128,500
Payback period (A)= 2 + (500/28,000)
=2.017 years
Project B
Year
Cumulative Amount
1
32,625
2
65,250
3
97875
4
130,500
Based on the above formula payback period for B
= 3 + (2125/32,625)
= 3.065 years.
Internal Rate of Return
This the minimum discount rate that an organization can use to identify future yields and pursue it. It is the rate at which the project will break even.
Internal Rate of Return is calculated by the following formula
= {CF1/(1+IRR)1 + CF2/(1/IRR)2 + ….n} - initial investment = 0
Therefore internal rate of return for project A (14%)
= {62,500/(1.14)1+ 30,000/(1.14)2 + 28,000/(1.14)3 + 10,000/(1.14)4} - 100,1000
= (54,824.56 + 23,076.92 + 18,899.76 + 5,920.66) - 100,000
= 102, 721.9 - 100,000
= 2,721.9
(16%)
= {62,500/(1.16)1 + 30,000/(1.16)2 + 28,000/(1.16)3 + 10,000/(1.16)4 } - 100,000
= (53879.31 + 22,294.89 + 17,938.37 + 5,523.03) - 100,000
= 99635.6 - 100,000
= -364.4
16% will be the IRR for project A since it gives a negative of 364.4
Project B's internal rate of return
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