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Calculating Payback Period & Comparing Investment Criteria

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Question 1

Payback (PB) calculation will give us an idea on how long it will take
for a project to recover the initial investment.
Then if:
Y = the year before full recovery of investment I;
U = Unrecovered cost at the start of last year;
CFi = CF of the year Y+1;

PB = Y + U/CFi

-Project A:

CFi = $18,000
I = $38,000
After the year 2 we will have recovered only $35,000 and we will
finish to recover the investment during the year 3, then:
Y = 2
and
U = $38,000 - $35,000 = $3,000
PB = 2 + 3,000/18,000 = 2.16 years

-Project B:

CFi = $250,000
I = $70,000
After the year 3 we will have recovered only $45,000 and we will
finish to recover the investment during the year 4, then:
Y = 3
and
U = $70,000 - $45,000 = $25,000
PB = 3 + 25,000/250,000 = 3.1 years

Definition of Payback Criterion:
-Accept a project if its payback period is less than maximum
acceptable payback period.
-Reject a project if its payback period is longer than maximum
acceptable payback period.

The payback cutoff is 3 years. Since project A has a payback period of 2.16 years, it should be selected.

Question 2

a. If you apply the payback criterion, which investment will you choose? Why?

Payback (PB) calculation will give us an idea on how long it will take
for a project to recover the initial investment.
Then if:
Y = the year before full recovery of investment I;
U = Unrecovered cost at the start of last year;
CFi = CF of the year Y+1;

PB = Y + U/CFi

-Project A:

CFi = $425,000
I = $210,000
After the year 3 we will have recovered only $77,000 ...

Solution Summary

The solution explains how to calculate the payback period and decide between mutually exclusive projects,

$2.19