Question

Payback method Assume a $90,000 investment and the following cash flows for two alternatives.

Year	Investment A	Investment B
1................	$25,000	$40,000
2................	30,000	40,000
3................	25,000	28,000
4................	19,000	—
5................	25,000	—

         a. Calculate the payback for investment A and B.

         b. If the inflow in the fifth year for Investment A was $25,000,000 instead of $25,000, would your answer change under the payback method?

Answer 1

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

Payback period of Investment A is computed as follows:

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

= $ 25,000 + $ 30,000 + $ 25,000

= $ 80,000

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

= $ 25,000 + $ 30,000 + $ 25,000 + $ 19,000

= $ 99,000

It means that the initial investment of $ 90,000 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 + ( $ 90,000 - $ 80,000) / $ 19,000

= 3.53 years Approximately

Payback period of Investment B is computed as follows:

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

= $ 40,000 + $ 40,000

= $ 80,000

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

= $ 40,000 + $ 40,000 + $ 28,000

= $ 108,000

It means that the initial investment of $ 90,000 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 + ( $ 90,000 - $ 80,000) / $ 28,000

= 2.36 years Approximately

b. The answer would not change since the investment of Investment A is recovered before the fifth year, since the payback period considers only the cash flows in which the initial investment of the investment is recovered.

Feel free to ask in case of any query relating to this question