Question

Assume a $95,000 investment and the following cash flows for two alternatives:

Year	Investment A			Investment B
1		$25,000			$30,000
2		15,000			30,000
3		30,000			40,000
4		30,000			—
5		20,000			—

Calculate the payback period for investment A and investment B. Show calculation. (Do not round intermediate calculations. Round the final answers to 2 decimal places.)

	Payback period
Investment A	years
Investment B	years

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 + $ 15,000 + $ 30,000

= $ 70,000

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

= $ 25,000 + $ 15,000 + $ 30,000 + $ 30,000

= $ 100,000

It means that the initial investment of $ 95,000 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 + ( $ 95,000 - $ 70,000) / $ 30,000

= 3.83 years Approximately

Payback period of Investment B is computed as follows:

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

= $ 30,000 + $ 30,000

= $ 60,000

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

= $ 30,000 + $ 30,000 + $ 40,000

= $ 100,000

It means that the initial investment of $ 95,000 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 3 cash inflow

= 2 years + ( $ 95,000 - $ 60,000) / $ 40,000

= 2.88 years Approximately

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