Long-term investment decision, payback method Personal Finance ProblemBill Willi

Question

Long-term investment decision, payback method Personal Finance ProblemBill Williams has the opportunity to invest in project A that costs $5,100 today and promises to pay annual cash flows of $2,300, $2,600, $2,600, $1,900 and $1,700 over the next 5 years. Or, Bill can invest $5,100 in project B that promises to pay annual cash flows of $1,600, $1,600, $1,600, $3,700 and $3,900 over the next 5 years. (Hint: For mixed stream cash inflows, calculate cumulative cash inflows on ayear-to-year basis until the initial investment is recovered.)

a.How long will it take for Bill to recoup his initial investment in project A?

b.How long will it take for Bill to recoup his initial investment in project B?

c.Using the payback period, which project should Bill choose?

d.Do you see any problems with his choice?

Explanation / Answer

Answer a Calculation of payback period of Project A Year Cash flow Cumulative Cash flow 0 -$5,100 -$5,100 1 $2,300 -$2,800 2 $2,600 -$200 3 $2,600 $2,400 4 $1,900 $4,300 5 $1,700 $6,000 Payback period of Project A = 2 Years + ($200/$2600) = 2.08 years i.e.approx 2 years 1 month Answer b Calculation of payback period of Project B Year Cash flow Cumulative Cash flow 0 -$5,100 -$5,100 1 $1,600 -$3,500 2 $1,600 -$1,900 3 $1,600 -$300 4 $3,700 $3,400 5 $3,900 $7,300 Payback period of Project B = 3 Years + ($300/$3700) = 3.08 years i.e.approx 3 years 1 month Answer c Project A has lower payback period , hence Bill should choose Project A. Answer d The total net cash inflow of project B is higher compared to Project A which results into higher return for Project B. Bill has to forgo this higher return if he decides to choose project A .

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