Question

You discovered a project opportunity which costs 74,000$ today. The project generates 12,000$ in two years, costs 4,000 in three years and then generates 30,000 for the next 5 years. What is the payback period of this project?

Answer 1

Payback period

Payback period is the time required for an investment to recover its cost.

When the annual cash inflows are equal, the formula for finding payback period is,

Payback period = Cost of project / Annual cash inflows

Here, the annual cash inflows from the project are unequal, so inorder to compute payback period you should find the cumulative cash flows.

Cost of the project = 74,000

It is given in the question that the project generates $12,000 in two years and costs $4000 in three years. Therefore cumulative cash flows for three years is -4000.

Year	Cash flows	Cumulative cash flows
2		12,000
3		-4,000
4	30,000	26,000
5	30,000	56,000
6	30,000	86,000
7	30,000
8	30,000

The project is able to recover its cost in the sixth year.

Payback period = Year immediately preceding the year of recovery + (amount left to be recovered / cash inflow during the year of final recovery)

note: Amount left to be recovered is the amount required in the final year to recoup the cost of project. So the amount left to be recovered = 74000 - 56000 = 18000

Payback period = 5 + (18000 / 30000)  

= 5 + 0.6

= 5.6 years

Therefore, payback period of the project is 5.6 years