Question

A company is considering two short-term projects. Based on the undiscounted payback period, which project is preferred? Month _A -$1,200 -$1800 $ 0 $ 400 $200 $ 400 $300 $ 300 $400 $ 500 $500 $ 200 $600 $ 100 O-Nmin

solve by hand

Answer 1

Project A:

Year	Opening Balance	Investment	CF	Closing Balance
0		$   1,200.00		$           1,200.00
1	$              1,200.00		$            -	$           1,200.00
2	$              1,200.00		$ 200.00	$           1,000.00
3	$              1,000.00		$ 300.00	$               700.00
4	$                  700.00		$ 400.00	$               300.00
5	$                  300.00		$ 500.00	$             -200.00
6	$                -200.00		$ 600.00	$             -800.00

• Opening balance = previous year's closing balance
• Closing balance = Opening balance+investment-CF
• We can see that at the end of 4 years, the closing balance was 300 and the CF in year 5 is 500, therefore assuming uniform inflow of CF, the 300 would have been earned in 300/500 x 12 month = 7.2month
• So payback period = 4 years and 7.2 months

Project B:

Year	Opening Balance	Investment	CF	Closing Balance
0		$   1,800.00		$           1,800.00
1	$              1,800.00		$ 400.00	$           1,400.00
2	$              1,400.00		$ 400.00	$           1,000.00
3	$              1,000.00		$ 300.00	$               700.00
4	$                  700.00		$ 500.00	$               200.00
5	$                  200.00		$ 200.00	$                        -
6	$                           -		$ 100.00	$             -100.00

• We can see that at the end of 4 years, the closing balance was 200 and the CF in year 5 is 200, leaving a closing balance of 0 in year 5 so payback period = 5 years

Project 1 has shorter payback period so it should be selected