Q & A Section 2

An investor borrows money at an effective rate of interest of 10% pa to invest in a 6-
year project with an internal rate of return of 18.7% pa. The cashflows for the project
are:
● an initial outlay of £25,000
● regular income of £10,000 pa during the first 5 years (assumed to be payable
continuously)
● regular expenditure of £2,000 pa during the first 5 years (assumed to be payable
continuously)
● a decommissioning expense of £5,000 at the end of the 6th year.
Calculate the discounted payback period for this project.


−25,000 + (10,000 − 2,000)at| = 0 [1]
which can be simplified to:
@10%
|
25,000 3.125
t 8,000

WHY don't we include the decommissioning expense in the NPV equation?

 

Actually at the time of finding Discounted Payback Period (DPP) our main motive is to get the tenure when the project cost is getting out of red. Here we can see that (10000-2000)=8000(continuously) is earned by the project per year. And the payback period is approx (25000/8000)=3 years.

Therefore we would not consider the Decommissioning Expenses as this is taking place after 6th year and our DPP is 3(approx) years.

 

hi

but in the question, we don't know the DPP until we find out. so, how do you know not to include the decommissioning expense?

 

As I said before, we need to get the approximate payback period. And the payback period is ruling out the decommissioning expense which occurred at the end of 6th year.

Our payback period is 3 year and thus we will ignore all the nominal expenses took place after it.

 

Since decommissioning expense is beyond payback period and therefore we would not consider it. To find out the DPP we have to get the payback period first.

 

thanks

thanks John.