Question

You are investing in a new business known informally as Zombiebook. The initial investment is $5 million. Future cash flows are projected to be $2 million at the end of years one, two, three, and four. A different business in which you are considering investing is called Angry Rabbits. It too would cost $5 million. Future cash flows for Angry Rabbits are projected to be $1 million at the end of years one, two, and three, followed by a positive cash flow of $20 million at the end of year 4. Compute the payback period for Zombiebook and for Angry Rabbits. On the basis of the two payback computations, which of the two companies would you choose? Does this choice cause you any concern?

Answer 1

Payback period = Cost of investment / Annual net cash flow

Zombiebook

= $ 5 Million / $ 2 Million

= 2.5 year

Angry Rabbits

In case of uneven cash flow following calculation is made

Year	Unrecovered at the beg	Investment	Cash inflow	Unrecovered at the year end
1		5 M	1 M	4 M
2	$ 4 M	-	1 M	3 M
3	3 M	-	1 M	2 M
4	2 M	-	20 M	-

= 5 year + (2 M / 20 M)

= 5 Year + 0.1 Year

= 5.1 Year Or 5 Year 1.2 months

Company with low payback period is accpetable therefore Zombiebook should be choosen.

This means that Amount invested will be realised in 2.5 years. Till such time there will be no Net cash inflow from project.