Question

5. Assume a $200,000 investment and the following cash flows for two alternative capital projects: Year Project A Project B 1 $60,000 $40,000 2 90,000 70,000 3 50,000 80,000 4 40,000 20,000 a. Calculate the payback period for each project. b. Using the payback method, if the projects are mutually exclusive, which project would you select and why? c. If the year four cash flows were $100,000 for Project A and $500,000 for Project B, would your decision change under the payback method? Why or why not?

Answer 1

a. Answers:

Payback Period of Project A = 3 Years

Payback Period of Project B = 3.50 Years

b. Answer = Project A

The project with the lower payback period would be chosen because this would mean that the cost is recovered faster for Project A.

c.Answer = No.

Project A would be chosen because the payback period for Project A is lower than that of Project B.

Notes:

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

= 2+ (50000/50000)

= 3 Years

Year	Investment	Cash Inflow	Net Cash Flow
0	-2,00,000.00	-	-2,00,000	(Investment + Cash Inflow)
1	-	60,000.00	-1,40,000	(Net Cash Flow + Cash Inflow)
2	-	90,000.00	-50,000	(Net Cash Flow + Cash Inflow)
3	-	50,000.00	-	(Net Cash Flow + Cash Inflow)
4	-	40,000.00	40,000	(Net Cash Flow + Cash Inflow)

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

= 3+(10000/20000)

= 3.50 Years

Year	Investment	Cash Inflow	Net Cash Flow
0	-2,00,000.00	-	-2,00,000	(Investment + Cash Inflow)
1	-	40,000.00	-1,60,000	(Net Cash Flow + Cash Inflow)
2	-	70,000.00	-90,000	(Net Cash Flow + Cash Inflow)
3	-	80,000.00	-10,000	(Net Cash Flow + Cash Inflow)
4	-	20,000.00	10,000	(Net Cash Flow + Cash Inflow)

c.

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

= 2+ (50000/50000)

= 3 Years

Year	Investment	Cash Inflow	Net Cash Flow
0	-2,00,000.00	-	-2,00,000	(Investment + Cash Inflow)
1	-	60,000.00	-1,40,000	(Net Cash Flow + Cash Inflow)
2	-	90,000.00	-50,000	(Net Cash Flow + Cash Inflow)
3	-	50,000.00	-	(Net Cash Flow + Cash Inflow)
4	-	1,00,000.00	1,00,000	(Net Cash Flow + Cash Inflow)

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

= 3+(10000/500000)

= 3.02 Years

Year	Investment	Cash Inflow	Net Cash Flow
0	-2,00,000.00	-	-2,00,000	(Investment + Cash Inflow)
1	-	40,000.00	-1,60,000	(Net Cash Flow + Cash Inflow)
2	-	70,000.00	-90,000	(Net Cash Flow + Cash Inflow)
3	-	80,000.00	-10,000	(Net Cash Flow + Cash Inflow)
4	-	5,00,000.00	4,90,000	(Net Cash Flow + Cash Inflow)