Question

A company is trying to decide between two projects. Project Musky will cost $250,000 to develop and have a net annual cash flow of $45,000. Project Perch will cost $300,000 to develop and have a net annual cash flow of $52,000. The company makes decisions based on payback period. Which project should they pick and why? For the one they should not pick, what would the net annual cash flow need to be to make it equal to the one they should pick?

Answer 1

Payback period of Project Musky = Initial Investment / Annual Net Cash Flows = $250000 / 45000 = 5.56 Years

Payback period of Project Perch = Initial Investment / Annual Net Cash Flows = $300000 / 52000 = 5.77 Years

Based Payback Period we choose the company whose payback period is lower Thus we choose Project Musky

To make the project perch payback period equal to Project Musky, the required net annual cash flow = initial investment of perch/ Payback period of Project Musky

the required net annual cash flow = 300000 / 5.56

the required net annual cash flow to make project perch equal to the project Musky = $54000