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Calculating payback period and YTM

1. Assume a $4,000 investment and the following cash flows for two alternatives.
Year Investment X Investment Y
1 $1,000 $1,300
2 800 2,800
3 700 100
4 1,900
5 2,000

a. Under the payback method, which investment should be chosen?
b. Why do other methods allow for a better analysis?

2. A ten-year bond pays 11% interest on a $1000 face value annually. If it currently sells for $1,195, what is its approximate yield to maturity?

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Solution:

Problem 1
a. Under the payback method, which investment should be chosen?

The payback period is the amount of time required for the firm to recover its initial investment.

Investment X Investment Y
Year Cash flow Cumulative Cash flow Cash flow Cumulative Cash flow
1 $1,000 $1,000 $1,300 $1,300
2 800 $1,800 2,800 $4,100
3 700 $2,500 ...

Solution Summary

There are two problems. Solution to first problem describes the steps to calculate payback period. Solution to second problem depicts the steps to calculate Yield to Maturity (YTM).

$2.19