Gander Inc. is considering two projects with the following cash flows: year Proj
ID: 2682774 • Letter: G
Question
Gander Inc. is considering two projects with the following cash flows:year Project X Project Y
0 (100,000) (100,000)
1 40,000 50,000
2 40,000 0
3 40,000 0
4 40,000 0
5 40,000 0
Gander uses the payback methiod of capital budgeting and accepts only rojects with payback of 3 years or less.
A- if the projects are presented as standalone opportunities whic one(s) would Gander accept? If they were mutually exclusive and Gander disregarded its three years rule, which project would be chosen?
B- Is there a flaw in the thinking behind the correct answer to part (A)?
Explanation / Answer
Project X has a payback period of 2.5 years. $100,000 / $40,000 = 2.5 Project Y has a payback period of 4.2 years. $50,000 + 0 + 0 +0 + .2(250,000) = $100,000 In a standalone context, payback will accept Project X and reject Project Y. In a mutually exclusive context, payback will choose Project X. ====================================== Yes, project Y is preferable in the longer run, yet the payback method chooses X. That’s because the method ignores cash flows that occur after the shortest payback period. This makes Payback Period a weak method. It’s generally used just to eliminate really bad projects, and shouldn’t be used blindly on Project Y.
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