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 is the time taken to recover the costs of the the project. Below table summarizes the CFs

Year	Opening Balance	CF	Closing Balance
1	$            74,000.00	$                                   -	74000-0 = $74,000.00
2	$            74,000.00	$                   12,000.00	74000-12000 = $62,000.00
3	$            62,000.00	$                    -4,000.00	62000-(-4000) = $66,000.00
4	$            66,000.00	$                   30,000.00	66000-30000= $36,000.00
5	$            36,000.00	$                   30,000.00	36000-30000 = $6,000.00
6	$              6,000.00	$                   30,000.00	6000- 30000= $-24,000.00

As the closing balance becomes negative at the end of year 6 it doesn't matter what the CFs are post this point. This is a big flaw of this method because if there is a big negative CF after this point, it is not considered in the decision making process.

Opening balance of year 1= Cost of the project or 74000
Opening balance = previous year's closing balance for all years after year 1
Closing balance = Opening balance - CF

The closing balance of year 5 was 6000 and the CF for year 6 was 30000 so the portion of year during which the 6000 is recovered is 6000/30000 = 0.2

So the payback period is 5.2 years

So the correct option is option 2