Question

WARM-UP EXERCISES All problems are available in MyLab Finance LG@ E10-1 Elysian Fields Inc. uses a maximum payback period of 6 years and currently must choose between two mutually exclusive projects. Project Hydrogen requires an ini- tial outlay of $25,000; project Helium requires an initial outlay of $35,000. Using the expected cash inflows given for each project in the following table, calculate each project's payback period. Which project meets Elysian's standards? Year Expected cash inflows (CF) Hydrogen Helium $6,000 $7,000 6,000 7,000 8,000 8,000 4,000 5,000 3,500 5,000 2,000 4,000

Answer 1

Payback for project Hydrogen:

Year	Cash flows	Cumulative cash flows
0	-          25,000	-                                   25,000
1	6,000	-                                   19,000
2	6,000	-                                   13,000
3	8,000	-                                     5,000
4	4,000	-                                     1,000
5	3,500	2,500
6	2,000

Cumulative cash flow is becoming positive in 5th year and so payback = 4 + 1000/3500 = 4.29 years

Payback for project Helium:

Year	Cash flows	Cumulative cash flows
0	-          35,000	-                             35,000.00
1	7,000	-                             28,000.00
2	7,000	-                             21,000.00
3	8,000	-                             13,000.00
4	5,000	-                               8,000.00
5	5,000	-                               3,000.00
6	4,000	1,000.00

We can see that Helium's cumulative cash flow is becoming positive in 6th year. So payback = 5 + 3000/4000 = 5.75 years

	Payback
Hydrogen	4.29	years
Helium	5.75	years

As we can see that for both the projects the payback is < 6 years and so both projects meet Elysian's standards. But Hydrogen has a lower payback than Helium and so Hydrogen will be selected.