3. Payback period is the time required for the operating cash inflows to recover the initial investment in a project.
First we will calculate the payback period of each projects.
Project A:
Here, initial investment = $60000
Cumulative cash flows after year 1 = $23000
Cumulative cash flows after year 2 = $23000 + $28000 = $51000
Cumulative cash flows after year 3 = $23000 + $28000 + $21000 = $72000
The cumulative cash flows reach the initial investment amount of $60000 sometime in year 3.
Therefore the payback period would be more than 2 years and less than 3 years. Steps in the calculation of payback period are given below:
a. Amount of cash flow in year 3 needed to reach $60000 cumulative cash flows:
$60000 - $51000 (year 2's cumulative cash flow amount) = $9000
b. Percentage of year 3 until cumulative amount of $60000 is reached:
$9000 / $21000 = 0.428571
c. Payback period = 2 + 0.428571 = 2.4286 years
Project B:
Here, initial investment = $70000
Cumulative cash flows after year 1 = $15000
Cumulative cash flows after year 2 = $15000 + $18000 = $33000
Cumulative cash flows after year 3 = $15000 + $18000 + $26000 = $59000
Cumulative cash flows after year 4 = $15000 + $18000 + $26000 + $230000 = $289000
The cumulative cash flows reach the initial investment amount of $60000 sometime in year 4.
Therefore the payback period would be more than 3 years and less than 4 years.
Since the cut off time of the company is 3 years, so it should accept the project with payback period less than 3 years.
Project A has payback period less than 3 years, so project A should be accepted.
need question 3 answered 2. Calculating Payback (LO2) An investment project provides cash inflows of $585...
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