Question

What is the payback period for the following set of cash flows?

Year      Cash Flow

0           -$6,400

1             1,600

2             1,900

3             2,300

4             1,400

A. 3.38 years

B. 3.45 years

C. 3.60 years

D. 3.43 years

E. 3.73 years

Answer 1

Option (D) is correct

Payback period is the time required for the operating cash inflows to recover the initial investment in a project.

Here, initial investment = $6400

Cumulative cash flows after year 1 = $1600

Cumulative cash flows after year 2 = $1600 + $1900 = $3500

Cumulative cash flows after year 3 = $1600 + $1900 + $2300 = $5800

Cumulative cash flows after year 4 = $1600 + $1900 + $2300 + $1400 = $7200

The cumulative cash flows reach the initial investment amount of $6400 sometime in year 4.

Therefore the payback period would be more than 3 years and less than 4 years. Steps in the calculation of payback period are given below:

a. Amount of cash flow in year 4 needed to reach $6400 cumulative cash flows:

$6400 - $5800 (year 3's cumulative cash flow amount) = $600

b. Percentage of year 4 until cumulative amount of $6400 is reached:

$600 / $1400 = 0.4285

c. Payback period = 3 + 0.4285 = 3.4285 = 3.43 years