Question

Assume a $100,000 investment and the following cash flows for two alternatives. Year л во мн Investment X $30,000 35,000 25,000 20,000 15,000 Investment Y $50,000 40,000 30,000 a. Calculate the payback for investment X and Y. (Do not round intermediate calculations. Round your answers to 2 decimal places.) Investment X years years Investment Y b. Which alternative would you select under the payback method? Investment X Investment Y

Answer 1

a) The Payback period (nothing but the traditional or conventional recovery period) is the period within which, cash outflows associated with the project can be recovered by the management but without considering time value of money. The answer is expressed in terms of number of periods (may be weeks or months or years, etc.). To calculate the payback period, cumulative cash flows year-by-year shall be calculated and then the year in which cumulative cash flows turns into positive is the payback period. However, in order to calculate exact payback period in decimal places, negative cumulative cash flows of previous year shall be divided by current year's cash flows and the decimal thus calculated shall be added to previous year to the year in which cumulative cash flows turned into positive. Year Net cash flow 0 $100,000 1 $30,000 Investment-X 2 3 $35,000 $25,000 4 $20,000 5 $15,000 Cumulative cash flow $100,000 $70,000 $35,000 $10,000 $10,000 $25,000 (Ref: NOTE] It is observed that the cumulative cash flow turns into positive in year-4. Therefore, simple payback period for the given cash flows should be: Investment-X's Payback period = 3.50 years [3 years +($10000 / $20000)] NOTE: Cumulative cash flow for year-1 = $100,000 + $30,000 = $70,000; year-2 = $70,000 + $35,000 = $35,000; year-3 = $35,000 + $25,000 = $10,000; year-4 = $10,000 + $20,000 = $10,000; year-5 = $10,000 + $15,000 = $25,000.

Year Net cash flow 0 1 $100,000 $50,000 Investment-Y 2 3 $40,000 $30,000 4 $0 5 $0 Cumulative cash flow $100,000 $50,000 $10,000 $20,000 $20,000 $20,000 [Ref: NOTE] It is observed that the cumulative cash flow turns into positive in year-3. Therefore, simple payback period for the given cash flows should be: Investment-Y's Payback period = 2.33 years [2 years +($10000 / $30000)] NOTE: Cumulative cash flow for year-1 = $100,000 + $50,000 = $50,000; year-2 = $50,000 + $40,000 = $10,000; year-3 = $10,000 + $30,000 = $20,000. b) Which alternative would you select under the payback method? Investment-Y Reason: As Investment-Y's payback period of 2.33 years is less than Investment-X's payback period of 3.5 years, Investment-Y should be selected so that investment amount can be recovered early.