Question

A firm is considering a project that requires an initial investment of $420,000. The life of this project is five years. Cash flows for each year are estimated as follows: Year 1 Year 2 Year 3 Year 4 Year 5 $180,000 $220,000 $160,000 -$20,000 -$80,000 If the cost of capital of this project is 8%, what is the payback period of this project?

Answer 1

Payback period can be defined as the time it would require a project to recover the initial investment made in it.

Calculation of Payback Period
Years	Cash flows ($)	Cumulative Cash flows ($)
0	(420,000)	(420,000)
1	180,000	(240,000)
2	220,000	(20,000)
3	160,000	140,000
4	(20,000)	120,000
5	(80,000)	40,000
Payback Period = 2 years + (20,000/160,000) =2.13 years

At year 2 the difference is ($20,000) but if we move to year 3 then we are starting to get positive cash flows of $140,000 from the project. Therefore the payback period has to lie between year 2 and year 3.

Therefore Payback period will be 2.13 years in which the project will be able to recover its initial investment.