# 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,