Question

Calculate the payback period for each of the following projects, then comment on the advisability of selection based on the payback period criterion in contrast to NPV: Project A has a cost of $15,000, returns $4,000 after-tax the first year and this amount increases by $1,000 annually over the five-year life; Project B costs $15,000 and returns $13,000 after-tax the first year, followed by four years of $2,000 per year. The firm uses a 10 percent discount rate.

Show each step.

Answer 1

Pay back period of project A
Time	Amount($)	Cumulative
-	-15,000.00	-15,000.00
1.00	4,000.00	-11,000.00
2.00	5,000.00	-6,000.00
3.00	6,000.00	-
4.00	7,000.00	7,000.00
5.00	8,000.00	15,000.00
Pay Back period is 3years
Pay back period of project B:
Time	Amount	Cumulative
-	-15,000.00	-15,000.00
1.00	13,000.00	-2,000.00
2.00	2,000.00	-
3.00	2,000.00	2,000.00
4.00	2,000.00	4,000.00
5.00	2,000.00	6,000.00
Pay back period is 2years
Using the pay back period alone, Project B looks more attractive as the payback period
of Project B is lower than Project A.However, The problem reinforces the fact that pay back
period ignores the timing of cash flows and also ignore the flows that occur beyond the
payback period and both of these factors are considered in case of NPV.