Question

Consider an investment of $150,000 that will generate the following cash flows:

Year1: $20,000

Year 2: $35,000

Year 3: $60,000

Year 4: $75,000

Year 5: $45,000.

The firm’s policy is to require a payback period of 3.4 years on new investments. What is the simple payback of this investment opportunity, and will the firm accept or reject it?

		A. 3.5 years - Accept
		D. 3.3 years - Reject
		B. 3.5 years - Reject
		C. 3.3 years - Accept

Answer 1

Year	Cash flows	Cumulative Cash flows
0	(150,000)	(150,000)
1	20,000	(130,000)
2	35000	(95000)
3	60,000	(35,000)
4	75,000	40,000
5	45,000	85000

Payback period=Last period with a negative cumulative cash flow+(Absolute value of cumulative cash flows at that period/Cash flow after that period).

=3+(35000/75000)

=3.5 years(Approx)

Hence since payback is greater than 3.4 years;project must be rejected.

Hence the correct option is:

3.5 years-Reject.