Question

Consider the following two investments:

                                                Project X         Project Y

            Initial investment        $100,000         $100,000

            Year 1 cash inflow      $50,000           $80,000

            Year 2 cash inflow      $40,000           $28,000

            Year 3 cash inflow      $30,000           $18,000

           

Ignore time value of money, which project has the shortest payback period?

a. project Y b. project x

Answer 1

Correct answer-------------a. project Y

Project Y has a lower payback period hence it should be accepted.

Working

Project X
Year	Net Cash Flow	Cumulative Cash Flow
0	$   (100,000.00)	$   (100,000.00)
1	$      50,000.00	$     (50,000.00)
2	$      40,000.00	$     (10,000.00)
3	$      30,000.00	$      20,000.00

.

Payback Period =	A+	B
		C

.

In the above formula,

A is the last period with a negative cumulative cash flow;

B is the absolute value of cumulative cash flow at the end of the period A;

C is the total cash flow during the period after A

.

Payback Period =	2+	$         10,000.00	0.33
		$         30,000.00
Payback Period =	2.33	Years

Project Y
Year	Net Cash Flow	Cumulative Cash Flow
0	$   (100,000.00)	$   (100,000.00)
1	$      80,000.00	$     (20,000.00)
2	$      28,000.00	$        8,000.00
3	$      18,000.00	$      26,000.00

.

Payback Period =	1+	$         20,000.00
		$         28,000.00
Payback Period =	1.71	Years