Question

The Great Outdoors is a company that manufactures canvas used for tents. The company needs to purchase new pressing equipment. The vice president of finance is considering two mutually exclusive presses. Each requires an initial investment of $100,000. The president of the company has stated that he wants a maximum payback period of 4 years. The cash inflows associated with each press are shown in the following table:

Cash Inflows

Year	Press A	Press B
1	$10,000	$40,000
2	$20,000	$30,000
3	$30,000	$20,000
4	$40,000	$10,000
5	$20,000	$20,000

Answer each of the following:

• Determine the payback period of each project.
• Because they are mutually exclusive, the vice president must choose one. Which one should the company invest in?
• Explain why one of the projects is a better choice than the other.

Answer 1

Project A

Press A :

The payback period is 4 years

Year	Press A Cash Flows	Cumulative Cash flows
0	-$100,000	-$100,000
1	$10,000	($90,000)
2	$20,000	($70,000)
3	$30,000	($40,000)
4	$40,000	$0
5	$20,000	$20,000

Press B :

The payback period is exactly 4 years

Year	Press B Cash Flows	Cumulative Cash flows
0	-$100,000	-$100,000
1	$40,000	($60,000)
2	$30,000	($30,000)
3	$20,000	($10,000)
4	$10,000	$0
5	$20,000	$20,000

Although both the presses have exactly the same Pay back period, the vice president should choose to invest in Press B.

The cash flows in the initial year are higher in Press B, which makes it less riskier for the company. If the cash flows do not follow the projected pattern, Press B would have returned a higher pay back in earlier years (1,2 & 3).

If the company were to use, time valued, discounted pay back period, Project B would have higher chance of approval.