Question

Blue Bird, Inc. situated on south Blue Hill Road is thinking about investing in two projects with the following cash flows. Year Project X Project Y 0 ($100,000) ($100,000) 1 40,000 50,000 2 40.000 0 3 40,000 0 4 40,000 0 5 40,000 250,000 Blue Bird uses the payback period method of capital budgeting and accepts only projects with payback periods of 3 years or less. a. If the projects are presented as standalone opportunities which one(s) would Blue Bird accept? If they were mutually exclusive and Blue Bird disregarded its three year rule, which project would be chosen? b. Is there a flaw in the thinking behind the correct answers to part a? Explain your answers. (10 points).

Answer 1

Part (a ):

Payback period of project X= 2.5 years

Payback period of project Y= 4.2 years

With the acceptable pay back period of 3 years, Only project X is acceptable.

Even if the 3 year norm is regarded, since it is mutually exclusive, project X with lower payback is accepted.

Calculation of payback period as follows:

Part (b):

Selection as in part (a) has the flaw that time value of money is not considered. Also, the impact of cash flows after the payback period is not considered. Hence the real profitability, in terms of total earning vs. cost as well as the difference in timing of cash flows, is not reflected in the decision. For example, total cash flows in the project X is $200,000 while that of project Y=$300,000. But this difference is ignored.