Question

Your company is currently considering two investment projects. Each project requires an upfront expenditure of $25 million. You estimate that the cost of capital is 10% and the investments will produce the following after tax cash flows:

Year	Project A	Project B
1	$5,000,000	$20,000,000
2	$10,000,000	$10,000,000
3	$15,000,000	$8,000,000
4	$20,000,000	$6,000,000

a) Calculate the payback period for both projects, then compare to identify which project the firm should undertake. [Note: you are supposed to show every step of your calculation and interpret the result.]

b) Evaluate the advantages and disadvantages of using the payback method in investment decisions and assess the situations where it should be used. [Note: remember to use Harvard referencing to reference your sources]

Answer 1

Payback Period for PROJECT-A

Year	Annual cash flows ($)	Cumulative annual cash flows ($)
0	-2,50,00,000	-2,50,00,000
1	50,00,000	-2,00,00,000
2	1,00,00,000	-1,00,00,000
3	1,50,00,000	50,00,000
4	2,00,00,000	2,50,00,000

Payback Period for Project-A = Years before full recover + (Unrecovered cash inflow at start of the year/cash flow during the year)

= 2.00 Years + ($1,00,00,000 / $1,50,00,000)

= 2.00 Years + 0.67 Years

= 2.67 Years

Payback Period for PROJECT-B

Year	Annual cash flows ($)	Cumulative annual cash flows ($)
0	-2,50,00,000	-2,50,00,000
1	2,00,00,000	-50,00,000
2	1,00,00,000	50,00,000
3	80,00,000	1,30,00,000
4	60,00,000	1,90,00,000

Payback Period for Project-B = Years before full recover + (Unrecovered cash inflow at start of the year/cash flow during the year)

= 1.00 Years + ($50,00,000 / $1,00,00,000)

= 1.00 Years + 0.50 Years

= 1.50 Years

DECISION

The firm should accept PROJECT-B, since the PROJECT-B has the lower payback period of 1.50 Years as compared to the Payback period of PROJECT-A.

PROJECTS PAYBACK PERIOD

- The Payback Period Method refers to the period in which the proposed project will generate the cash inflows to recover the Initial Investment costs. In Capital Budgeting Method, The Payback Period method does not use the concept of Time Value of money. It considers only three components such as Initial Investment costs, Economic life of the project and the annual cash inflows

- Payback period is the number of years taken to recover the total amount of money invested in the project. If the payback period is less than the enterprises required number of years, then the project should be accepted, Else it is rejected. In the Discounted Payback Period Approach, it considers the concept of time value of money- The Payback Period Method refers to the period in which the proposed project will generate the cash inflows to recover the Initial Investment costs.

- In Capital Budgeting Method, The Payback Period method does not use the concept of Time Value of money

- It considers only three components such as Initial Investment costs, Economic life of the project and the annual cash inflows

- It does not consider the concept of time value of money

- Payback period computes the number of years taken to recover the total amount of money invested in the project

- If the payback period is less than the enterprises required number of years, then the project should be accepted, Else it is rejected

- In the Discounted Payback Period Approach, it considers the concept of time value of money

Formula is used to calculate payback period

There are mainly two types of cash flows – Annual Equal cash inflows and Uneven cash flows.

Payback Period for Annual Equal cash flows

Payback Period = Initial Investment / Annual Cash inflows

Payback Period for Uneven Cash inflows.

Payback Period = Years Before Full Recover + (Unrecovered cash inflow at start of the year / Cash Inflow during the year)