Question

7)      A company uses the payback method to evaluate capital budgeting projects.  It is currently considering projects A, B and C.

Project A             Project B              Project C

Initial cost (cash outflow)                         $10,000               $10,000               $10,000

Cash inflows:

1^st year                                             $  1,000                 $9,000                  $  5,000

2^nd year   $9,000                 $1,000                   $5,000

3^rd year $15,000       - 0 -                    $35,000

a)      Find the payback period for each of the above capital budgeting projects.  Label the payback period for each project so I can see which payback period goes with which project.

b)      What two major weaknesses of the payback method are illustrated by this problem?  Explain each.

Answer 1

Let us find the cumulative cash flows for each project. Payback period is the period when the cumulative cash flows become positive.

Project A
Year	Cash Flow	Cumulative
0	-10000	-10000
1	1000	-9000
2	9000	0
3	15000	15000
Project B
Year	Cash Flow	Cumulative
0	-10000	-10000
1	9000	-1000
2	1000	0
3	0	0
Project C
Year	Cash Flow	Cumulative
0	-10000	-10000
1	5000	-5000
2	5000	0
3	35000	35000

Payback for Project A = 2 years
Payback for Project B = 2 years
Payback for Project C = 2 years

(b) The payback period does not take into account the (i) the cash flows of the projects (ii) time period of the cash flows of the project (discounting effect)

This can lead to incorrect decision, since a project with lower payback can have lower NPV as well, leading to incorrect project selection