Question

# Pay Back Method What is the payback period for the following project?                     Year          &n

1. 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

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