Question

​Long-term investment​ decision, payback method (Personal Finance Problem) - Bill Williams has the opportunity to invest in project A that costs $8,500 today and promises to pay $2,100, $2,400, $2,400, $2,100, and $1,700 over the next 5 years. Or, Bill can invest $8,500 on project B that promises to pay $1,500, $1,500, $1,500, $3,700, and $3,900 over the next 5 years. (​Hint: For mixed stream cash​ inflows, calculate cumulative cash inflows on a​ year-to-year basis until the initial investment is recovered.​)

a.  How long will it take for Bill to recoup his initial investment in project​ A?

b.  How long will it take for Bill to recoup his initial investment in project​ B?

c.  Using the payback​ period, which project should Bill​ choose?

d.  Do you see any problems with his​ choice?

Answer 1

Payback period is the time period in which the initial investment is recovered

a.Project A

Year	Cash Flows	Cumulative cash flows
0	-8,500	-8,500
1	2,100	-6,400
2	2,400	-4,000
3	2,400	-1,600
4	2,100	500
5	1,700	2,200

Payback period = 3 + 1,600/2,100

= 3.76 years

B.Project B:

Year	Cash Flows	Cumulative cash flows
0	-8,500	-8,500
1	1,500	-7,000
2	1,500	-5,500
3	1,500	-4,000
4	3,700	-300
5	3,900	3,600

Payback period = 4 + 300/3,900

= 4.08 years

c.Using Payback period, Bill should choose Project A

d.Yes, cash flows from project B are more. Since they are in later years, they are not considered in the payback period.