Question

Company XYZ is considering an investment of $100,000. The useful life of the project is 10 years. The cut off period is three (3) years. The board of the directors has identified two alternatives A and B. The expected annual cash flows are as follows:

Cost of Cash Flow	Alternative A	Alternative B
Initial Cost	($100,000)	($100,000)
Cash Flow Year 1	35000	35000
Cash Flow Year 2	28000	35000
Cash Flow Year 3	32000	35000
Cash Flow Year 4	40000	35000

1. Calculate the payback period for Alternative A and B

2. Briefly explain which alternative should be selected based on the payback method

3.What are the limitations of using such a method(payback method) to appraise investment?

Answer 1

Answer : Calculation of Payback Period :

Below is the table showing calculation of Payback Period for Alternative A :

Year	Cash Flows	Cumulative Cash Flows
1	35000	35000
2	28000	63000
3	32000	95000
4	40000	135000

Payback Period = Complete Years + Remaining Cash flow / Cashflow for the year to be recovered

= 3 years + (100000 - 95000) / 40000

= 3.125 years

Payback Period of Alternative B = Initial Investment / Annual Cash Flows

= 100000 / 35000

= 2.86 years

2.) Alternative B should be selected as The cut off of the project is 3 years and in Alternative B cash Flow will be recovered within 3 years.

3.)

Pay back period is the time taken to recover the original investment from project Cash flows . It is also called break even period

Limitations of Payback Period :

(a.) It suffers from the limitation of ignoring the time value of money which is biggest disadvantage

(b.) It do not consider the cash Flows received after the payback period.

(c.) If project has a short payback period it will be selected. But sometimes it is not true.There are cases where cashflows of project end at payback or is reduced which may not be a profitable investment. therefore it sometime leads to inaccurate decision making.