Question

Chapter 11 Exercise A4

Assume a company is going to make an investment of $450,000 in a machine and the following are the cash flows that two different products would bring in years one through four.

Option A, Product A			Option B, Product B
$190,000			$150,000
190,000			180,000
60,000			60,000
20,000			70,000

Which of the two options would you choose based on this payback method?

Answer 1

Option A should be selected.

Option A has a lower payback period than Option B.

Working

Payback period calculation for Option A, Product A
Year	Cash inflows	Cash outflows	Net Cash inflows	Cumulative Cash flow
0	-$ 450,000			-$ 450,000
1	$ 190,000		$ 190,000	-$ 260,000
2	$ 190,000		$ 190,000	-$ 70,000
3	$ 60,000		$ 60,000	-$ 10,000
4	$ 20,000		$ 20,000	$ 10,000
Payback period (3 years + (10000/20000))				3.5	Years

.

Payback period calculation for Option B, Product B
Year	Cash inflows	Cash outflows	Net Cash inflows	Cumulative Cash flow
0	-$ 450,000			-$ 450,000
1	$ 150,000		$ 150,000	-$ 300,000
2	$ 180,000		$ 180,000	-$ 120,000
3	$ 60,000		$ 60,000	-$ 60,000
4	$ 70,000		$ 70,000	$ 10,000
Payback period (3 years + (60000/70000))				3.86	Years