Question

(a) Company EEF ltd is considering an investment of €100,000. The desired payback period is 3 years. The board of directors have identified two alternatives; project A and project B.

The expected annual cash flows are as follows:

Cash flow: Project A       Project B

(-)       (-)

Y0 100,000.00 100,000.00

Y1                          35,000.00          35,000.00

Y2                          28,000.00          35,000.00

Y3                      32,000.00          35,000.00

Y4                      40,000.00             35,000.00

Required: Calculate the Payback period of each project and advise EEF’s board of directors which project they should invest in.

Answer 1

A		B
Year	Cash Flow	Cumulative Cashflow (currecnt cash flow + all previous cashflows)		Year	Cash Flow	Cumulative Cashflow (currecnt cash flow + all previous cashflows)
1	35000	35000		1	35000	35000
2	28000	63000		2	35000	70000
3	32000	95000		3	35000	105000
4	40000	135000		4	35000	140000
		As Initial Outlay is 100000, it will be recoverd in between year 3 & 4. Therefore, Payback Period will be between 3rd and 4th year.				As Initial Outlay is 100000, it will be recoverd in between year 2 & 3. Therefore, Payback Period will be between 2nd and 3rd year.
		Payback Period will be 3 years + proportionate of 4th year Payback Pariod = 3+[(100000-95000)/(135000-95000)]				Payback Period will be 2 years + proportionate of 3rd year Payback Pariod = 2+[(100000-70000)/(105000-70000)]
		Payback Period = 3.125 years				Payback Period = 2.857 years

Project B has Lower Payback Period & it is also LESS THAN 3. Therefore, Project B should be chosen.