Question

4. Pay Back Method

What is the payback period for the following project?

                    Year                            Inflow/(Outflow)

1. ($38,000)
2. $   8,000
3. $   9,000
4. $ 12,000
5. $   7,000
6. $   8,000
7. $   5,000
8. $   3,000

Answer 1

Payback period is the time required for the operating cash inflows to recover the initial investment in a project.

Here, initial investment = $38000

Cumulative cash flows after year 1 = $8000

Cumulative cash flows after year 2 = $8000 + $9000 = $17000

Cumulative cash flows after year 3 = $8000 + $9000 + $12000 = $29000

Cumulative cash flows after year 4 = $8000 + $9000 + $12000 + $7000 = $36000

Cumulative cash flows after year 5 = $8000 + $9000 + $12000 + $7000 + $8000 = $44000

The cumulative cash flows reach the initial investment amount of $38000 sometime in year 5.

Therefore the payback period would be more than 4 years and less than 5 years. Steps in the calculation of payback period are given below:

a. Amount of cash flow in year 5 needed to reach $38000 cumulative cash flows:

$38000 - $36000 (year 4's cumulative cash flow amount) = $2000

b. Percentage of year 5 until cumulative amount of $38000 is reached:

$2000 / $8000 = 0.25

c. Payback period = 4 + 0.25 = 4.25 years