Question

A prposed capital project will produce $5,000 per year in incremental cash flows over its useful life of 15 years. If the project has a payback period of five years, the cash flows received in years 6-15 will be ignored in the calculation of the payback period. true or false

Answer 1

Answer:-

Meaning of Payback period- Payback period means the period in which the amount invested can be recovered. In other words, the point at which Net Present Value is zero.

Calculation of Payback Period- Payback period varies from on the basis of nature of cash flows, hence formula for calculation of payback period is also different:-

1. Payback Period for projects having even cash flows:-

                                                        (Net Initial Investment/Annual Cash Flow)

2. Payback period for the projects having uneven cash flow:-

Example:-

Year	Cash Flow	Cumulative Cash Flow
0	-25,100	-25,100
1	2,000	-23,100
2	5,000	-18,100
3	7,000	-11,100
4	9,000	-2,100
5	8,000	5,900
6	4,000	9,900

In the above example, we can observe that we require 2,100 in year 5 against 8,000. This means payback period is in between year 4 and 5. Then for remaining 2,100 we will divide this by the total cash flow for the year 5. Thus, (2,100/8,000=.26 years) 4+0.26= 4.26 years is our payback period.

Use- We use payback period to decide in which project we should invest, earlier maximum organisation were using this method but now a days it is not so popular. Mostly this method is useful for smaller period project.

Limitations- This method has following two limitations:-

1. Ignore time value of money.
2. No role of cash flow after payback period.

Facts- In the given case the project has incremental cash flow of $5,000 per year and life of project is 15 years, while payback period is 5 years.

Conclusion- As the life of project is not small so we should not take the decision only on the basis of Payback Period Method. This method has already its limitation of ignorance of cash flow after the payback period. From the example stated above we also can observe that we didn’t consider year 6 for the purpose of payback period. Hence, we can conclude that given statement is true.