Question

Assume a $45,000 investment and the following cash flows for two alternatives:

Year	Investment A		Investment B
1	$10,000		$10,000
2	15,000		15,000
3	15,000		30,000
4	15,000		—
5	3,900,000		—

  

Calculate the payback for investment A and B. (Round the final answers to 2 decimal places.)

   

	Payback period
Investment A	years
Investment B	years

  

Which of the alternatives would you select under the payback method?

• Investment A

• Investment B

Answer 1

A:

Year	Cash flows	Cumulative Cash flows
0	(45000)	(45000)
1	10,000	(35000)
2	15000	(20,000)
3	15000	(5000)
4	15000	10,000
5	3,900,000	3,910,000

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+(5000/15000)

=3.33 years(Approx)

B:

Year	Cash flows	Cumulative Cash flows
0	(45000)	(45000)
1	10,000	(35000)
2	15000	(20,000)
3	30,000	10,000

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

=2+(20,000/30,000)

=2.67 years(Approx)

Hence B must be selected having lower payback.