Question

Long-term investment decision, payback method Personal Finance Problem Bill Williams has the opportunity to invest in project A that costs

$ 6 comma 300$6,300

today and promises to pay

$ 2 comma 300$2,300 ,

$ 2 comma 500$2,500 ,

$ 2 comma 500$2,500 ,

$ 2 comma 000$2,000

and

$ 1 comma 800$1,800

over the next 5 years. Or, Bill can invest

$ 6 comma 300$6,300

in project B that promises to pay

$ 1 comma 300$1,300 ,

$ 1 comma 300$1,300 ,

$ 1 comma 300$1,300 ,

$ 3 comma 700$3,700

and

$ 4 comma 000$4,000

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	-6,300	-6,300
1	2,300	-4,000
2	2,500	-1,500
3	2,500	1,000
4	2,000	3,000
5	1,800	4,800

Payback period = 2 + 1,500/2,500

= 2.6 years

B.Project B:

Year	Cash Flows	Cumulative cash flows
0	-6,300	-6,300
1	1,300	-5,000
2	1,300	-3,700
3	1,300	-2,400
4	3,700	1,300
5	4,000	5,300

Payback period = 3 + 2,400/3700

= 3.65 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.