Question

Rubinstein Associates is considering a project that has the following cash flow data. What is the project's payback?

Cash flows Year 0:-$1,975 Year 1: $900 Year 2: $310 Year 4: $515 Year 5: $600 Year 6: $340

Answer 1

Payback period is the time required for the cash flows to recover the initial investment.

Initial investment = $1975

Here, in the question, the cash flows in year 3 are not given, so it is assumed here that there are no cash flows in year 3. Or the cash flows in year 3 is zero.

Cumulative cash flows reach the initial investment amount of $1975 sometime in year 5.(i.e. $900 + $310 + $0 + $515 + $600)

Therefore, the payback period would be more than 4 years and less than 5 years.

Payback period is calculated as per the below steps:

(a) Amount of cash flow in year 4 needed to attain $1975 cumulative cash flows:

$1975 - $1725 (Year 4's cumulative amount) = $250

(year 4's cumulative amount is $900 + $310 + $0 + $515 = $1725)

(b) Percentage of year 5 until cumulative amount of $1975 is attained:

$250 / $600 = 0.4167

(c) Payback period = 4 + 0.4167 = 4.4167