Question

Please Use TI BAII Plus Calculator and Show How You Get the Answer with it.

The TurtlesandWhales Company wants to calculate how long it will take to recover their initial investment on a project, Project X. It is assumed that the estimated cash flows are received evenly throughout the year.
Cost 100,000
Year 1 $53,000
Year 2 $30,000
Year 3 $30,000
Year 4 $100,000
a) What is the payback period? (Give partial year to two decimal places.  SHOW ALL WORK).

b) Compared to another project, Project Y, with a payback period of 3 years, which project should be chosen?

c) In evaluation of Project X, what is the primary drawback of the payback method?

Answer 1

(a) To calculate the payback period, we need to calculate the cumulative cash flows

Payback period is the period when the cumulative cash flow becomes positive i.e. the costs are recovered

Year	Cash Flow	Cumulative Cash Flow
0	-100000	-100000
1	53000	-47000
2	30000	-17000
3	30000	13000
4	100000	113000

Hence, the cash flow becomes positive after 2nd year

=> Payback period = 2 + 17000/30000 = 2.57 years

(b) Payback of Project X = 2.57 years

Payback of Project Y = 3 years

Since X has lower payback period, Project X should be selected

(c) The main drawback in using the payback method is that discounting is not taken into account. The payback period should be calculated after taking discounting into account i.e. discounted payback period.