Question

Evaluate the following projects using the payback method assuming a rule of 4 years for payback.

Year Project A Project B

0. -10,000 -10,000

1. 4000 4000

2. 4000 3000

3. 4000 2000

4. 0. 1,000,000

	A.	Project A can be accepted because the payback period is 2.5 years but Project B cannot be accepted because its payback period is longer than 3 years.
	B.	Project B should be accepted, since there is a $1,000,000 payoff in the 4th year in Project B
	C.	Project B should be accepted because you get more money paid back in the long run.
	D.	Both projects can be accepted because the payback is less than 4 years.

Answer 1

Payback period represents the time period in which the initial investment in a project is recovered.

Payback period of Project A is computed as follows:

The cumulative cash inflow of year 1 and 2 is computed as follows:

= $ 4,000 + $ 4,000

= $ 8,000

The cumulative cash inflow of year 1, 2 and 3 is computed as follows:

= $ 4,000 + $ 4,000 + $ 4,000

= $ 12,000

It means that the initial investment of $ 10,000 is recovered between year 2 and year 3 and hence the payback period lies between year 2 and year 3 and is computed as follows:

= 2 years + Remaining investment to be recovered / Year 4 cash inflow

= 2 years + ( $ 10,000 - $ 8,000) / $ 4,000

= 2.50 years

Payback period of Project B is computed as follows:

The cumulative cash inflow of year 1, 2 and 3 is computed as follows:

= $ 4,000 + $ 3,000 + $ 2,000

= $ 9,000

The cumulative cash inflow of year 1, 2, 3 and 4 is computed as follows:

= $ 4,000 + $ 3,000 + $ 2,000 + $ 1,000,000

= $ 1,009,000

It means that the initial investment of $ 10,000 is recovered between year 3 and year 4 and hence the payback period lies between year 3 and year 4 and is computed as follows:

= 3 years + Remaining investment to be recovered / Year 4 cash inflow

= 3 years + ( $ 10,000 - $ 9,000) / $ 1,000,000

= 3.001 years

Since the payback period of both projects lies within the acceptable payback period of 4 years, hence both the projects are acceptable.

So, the correct answer is option D.

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