Question

Blanda Incorporated management is considering investing in two alternative production systems. The systems are mutually exclusive, and the cost of the new equipment and the resulting cash flows are shown in the accompanying table. If the firm uses a 9 percent discount rate for their production systems.

Year			System 1			System 2
0			-$15,100			-$42,300
1			15,100			30,800
2			15,100			30,800
3			15,100			30,800

What are the payback periods for production systems 1 and 2? (Round answers to 2 decimal places, e.g. 15.25.)

Payback period of System 1 is years and Payback period of System 2 is years

If the systems are mutually exclusive and the firm always chooses projects with the lowest payback period, in which system should the firm invest?

The firm should invest in

System 2System 1

.

Answer 1

NPV of System 1 = PV of cash inflows - Initial Investment

= 15100/(1.09) + 15100/(1.09)^2 + 15100/(1.09)^3 - $15100

= $38222.55 -$15100

= $23123

NPV of System 2

= 30800/(1.09) + 30800/(1.09)^2 + 30800/(1.09)^3 - $42300

= $77963.88 -$42300

= $35663.88

System 1 has payback period of exactly one year because the initial investment and cashflow in the year 1 is same.

System 2 has a payback period of = Sum of cash flows in year 1 and year 2 / Initial Investment

= 30800+30800/42300

= 1.46 years.

Given the shorter playback period criteria system 1 has shorter playback period so Investment should be made in system 1.