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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,

    $2.49

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