Question

1. You are considering three independent projects: A, B, and C. Given the following free cash flow information, calculate the payback period for each. Required rate of return is 9%. (1 Mark)

If you require a 3-year payback before an investment can be accepted, which project(s) would be accepted? (0.5 Mark)

Year	Project A	Project B	Project C
0	(1,000)	(9,000)	(4,000)
1	300	4,000	1,100
2	400	2,000	1,800
3	250	2,000	2,200
4	125	3,000	2,800
5	125	5,000	3,200

Answer 1

Payback Period = ( Last Year with a Negative Cash Flow ) + [( Absolute Value of negative Cash Flow in that year)/ Total Cash Flow in the following year)]

Project A :

Payback Period = 2 + ( 300 / 250)

= 3.20 Years

Hence the correct answer is 3.20 Years

Note:

Year	Investment	Cash Inflow	Net Cash Flow
0	-1,000	-	-1,000	(Investment + Cash Inflow)
1	-	300	-700	(Net Cash Flow + Cash Inflow)
2	-	400	-300	(Net Cash Flow + Cash Inflow)
3	-	250	-50	(Net Cash Flow + Cash Inflow)
4	-	125	75	(Net Cash Flow + Cash Inflow)
5	-	125	200	(Net Cash Flow + Cash Inflow)

Project B :

Payback Period = 3 + ( 1000 / 3000)

= 3.33 Years

Hence the correct answer is 3.33 Years

Note:

Year	Investment	Cash Inflow	Net Cash Flow
0	-9,000	-	-9,000	(Investment + Cash Inflow)
1	-	4,000	-5,000	(Net Cash Flow + Cash Inflow)
2	-	2,000	-3,000	(Net Cash Flow + Cash Inflow)
3	-	2,000	-1,000	(Net Cash Flow + Cash Inflow)
4	-	3,000	2,000	(Net Cash Flow + Cash Inflow)
5	-	5,000	7,000	(Net Cash Flow + Cash Inflow)

Project C :

Payback Period = 2 + (1100 / 2200)

= 2.5 Years

Hence the correct answer is 2.50 Years

Note:

Year	Investment	Cash Inflow	Net Cash Flow
0	-4,000	-	-4,000	(Investment + Cash Inflow)
1	-	1,100	-2,900	(Net Cash Flow + Cash Inflow)
2	-	1,800	-1,100	(Net Cash Flow + Cash Inflow)
3	-	2,200	1,100	(Net Cash Flow + Cash Inflow)
4	-	2,800	3,900	(Net Cash Flow + Cash Inflow)
5	-	3,200	7,100	(Net Cash Flow + Cash Inflow)

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If the required payback is 3-year payback before an investment can be accepted, project C would be accepted

Hence the correct answer is project C