Question

​Long-term investment​ decision, payback method Personal Finance Problem Bill Williams has the opportunity to invest in project A that costs $8,300 today and promises to pay $2,300 $2,600​, $2,600​, $2,00 and $1,800 over the next 5 years. ​ Or, Bill can invest $8,300 in project B that promises to pay $1,600​, $1,600​, $1,600​, $3,700 and $3,900 over the next 5 years.  

​(​Hint: For mixed stream cash​ inflows, calculate cumulative cash inflows on a​ year-to-year basis until the initial investment is recovered.​)

a.  For Bill to recoup his initial investment in project​ A, it will take ? years.  ​(Round to two decimal​ places.)

b.  For Bill to recoup his initial investment in project​ B, it will take ? years.  ​(Round to two decimal​ places.)

c.  Using the payback​ period, which project should Bill​ choose?  ​(Select the best answer​ below.)

Project Upper A would be preferred over project Upper B because its payback period is longer.

Project Upper B would be preferred over project Upper A because its payback period is shorter.

d.  Do you see any problems with his​ choice?  ​(Select the best answer​ below.)

A. One strength of the payback method is that it disregards expected future cash flows as in the case of project B.

B. One weakness of the payback method is that it disregards expected future cash flows as in the case of project B.

C. One strength of the payback method is that it disregards expected future cash flows as in the case of project A.

D. One weakness of the payback method is that it takes into account the expected future cash flows as in the case of project B.

Answer 1

a) Statement showing cummulative cash flow for project A

Year	Cash flow	Cummulative cash flow
1	2300	2300
2	2600	4900
3	2600	7500
4	200	7700
5	1800	9500

Now interpolation method will be used to find payback period

Year	Cummulative cash flow
4	7700
5	9500
1	1800
?	600

=600/1800

=0.33

Thus payback period = 4+0.33 = 4.33 years

b) Statement showing cummulative cash flow for project B

Year	Cash flow	Cummulative cash flow
1	1600	1600
2	1600	3200
3	1600	4800
4	3700	8500
5	3900	12400

Now interpolation method will be used to find payback period

Year	Cummulative cash flow
3	4800
4	8500
1	3700
?	3500

=3500/3700

=0.95

Thus payback period = 3+0.95 = 3.95 years

c) Project Upper B would be preferred over project Upper A because its payback period is shorter.

d) B. One weakness of the payback method is that it disregards expected future cash flows as in the case of project B.