Question

Assume a $52,000 investment and the following cash flows for two alternatives.

Year	Investment A	Investment B
1	$15,000	$25,000
2	15,000	15,000
3	15,000	20,000
4	10,000	-
5	15,000	-

a. Calculate the payback for investment A and B. Round your answers to 2 decimal places.

Investment A		years
Investment B		years

b. Which investment would you select under the payback method?

-Investment A

-Investment B

c. If the inflow in the fifth year for Investment A was $15,000,000 instead of $15,000, would your answer change under the payback method?

-Yes

-No

Answer 1

a.

A:

Year	Cash flows	Cumulative Cash flows
0	(52000)	(52000)
1	15000	(37000)
2	15000	(22000)
3	15000	(7000)
4	10000	3000
5	15000	18000

Hence Payback period=Last period with a negative cumulative cash flow+(Absolute value of cumulative cash flows at that period/Cash flow after that period).

3+(7000/10000)

=3.7 years.

B:

Year	Cash flows	Cumulative Cash flows
0	(52000)	(52000)
1	25000	(27000)
2	15000	(12000)
3	20000	8000

Hence Payback period=Last period with a negative cumulative cash flow+(Absolute value of cumulative cash flows at that period/Cash flow after that period).

2+(12000/2000)

=2.6 years

Investment A	3.7 years
Investment B	2.6 years

b.Hence B is better having lower payback.

c.Payback method considers cash flows only till the time period the initial investment is recovered .Hence cash flow change for year 5 for investment A would not affect the payback decision.

Hence the correct option is 'No'.