Long-term investment decision, payback method Personal Finance Problem Bill Williams has the opportunity to invest in project A that costs
$ 5 comma 200$5,200
today and promises to pay
$ 2 comma 300$2,300 ,
$ 2 comma 500$2,500 ,
$ 2 comma 500$2,500 ,
$ 2 comma 100$2,100
and
$ 1 comma 700$1,700
over the next 5 years. Or, Bill can invest
$ 5 comma 200$5,200
in project B that promises to pay
$ 1 comma 400$1,400 ,
$ 1 comma 400$1,400 ,
$ 1 comma 400$1,400 ,
$ 3 comma 600$3,600
and
$ 3 comma 900$3,900
over the next 5 years.
( Hint:
For mixed stream cash inflows, calculate cumulative cash inflows on a year-to-year basis until the initial investment is
recovered. )
a. How long will it take for Bill to recoup his initial investment in project A?
b. How long will it take for Bill to recoup his initial investment in project B?
c. Using the payback period, which project should Bill choose?
d. Do you see any problems with his choice?
Payback period is the time period in which the initial investment is recovered
a.Project A
Year |
Cash Flows |
Cumulative cash flows |
0 |
-5,200 |
-5,200 |
1 |
2,300 |
-2,900 |
2 |
2,500 |
-400 |
3 |
2,500 |
2,100 |
4 |
2,100 |
4,200 |
5 |
1,700 |
5,900 |
Payback period = 2 + 400/2,500
= 2.16 years
B.Project B:
Year |
Cash Flows |
Cumulative cash flows |
0 |
-5,200 |
-5,200 |
1 |
1,400 |
-3,800 |
2 |
1,400 |
-2,400 |
3 |
1,400 |
-1,000 |
4 |
3,600 |
2,600 |
5 |
3,900 |
6,500 |
Payback period = 3 + 1,000/3,600
= 3.28 years
c.Using Payback period, Bill should choose Project A
d.Yes, cash flows from project B are more. Since they are in later years, they are not considered in the payback period.
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