Calculate the payback period for each of the following mutually exclusive projec

Question

Calculate the payback period for each of the following mutually exclusive projects, then comment on the advisability of selection based on the payback period criterion and compare the selecting suggestion with NPV method : Project A has a cost of $15,000, returns $4,000 after-tax the first year with this amount increasing by $1,000 annually over a 5-year life; Project B costs $15,000 and returns $13,000 after-tax the first year, followed by 4 years of $2,000 per year. The firm uses a 10% discount rate.
Calculate the payback period for each of the following mutually exclusive projects, then comment on the advisability of selection based on the payback period criterion and compare the selecting suggestion with NPV method : Project A has a cost of $15,000, returns $4,000 after-tax the first year with this amount increasing by $1,000 annually over a 5-year life; Project B costs $15,000 and returns $13,000 after-tax the first year, followed by 4 years of $2,000 per year. The firm uses a 10% discount rate.
Calculate the payback period for each of the following mutually exclusive projects, then comment on the advisability of selection based on the payback period criterion and compare the selecting suggestion with NPV method : Project A has a cost of $15,000, returns $4,000 after-tax the first year with this amount increasing by $1,000 annually over a 5-year life; Project B costs $15,000 and returns $13,000 after-tax the first year, followed by 4 years of $2,000 per year. The firm uses a 10% discount rate.

Explanation / Answer

Payback Period = A + B/C where A = the last negative cumulative cash flow B = the absolute value of cumulative cash flow at the end of the period A C = the total cash flow during the period after A Project A Year Cash flow Cumulative cash flow 0 -15000 -15000 1 4000 -11000 2 5000 -6000 3 6000 0 4 7000 7000 5 8000 15000 Payback Period = 2 + (|-6000| ÷ 6000) = 3 years Project B Year Cash flow Cumulative cash flow 0 -15000 -15000 1 13000 -2000 2 2000 0 3 2000 2000 4 2000 4000 5 2000 6000 Payback Period = 1 + (|-2000| ÷ 2000) = 2 years The payback period is shorter for Porject B (2 years instead of 3 years) but the cumulative cash flow is larger for Project A (15000 instead of 6000).

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