Long-term investment decision, payback method Personal Finance Problem Bill Will

Question

Long-term investment decision, payback method Personal Finance Problem Bill Williams has the opportunity to invest in project A that costs $6,100 today and promises to pay annual cash flows of $2,100, $2,400, $2,400, $2,100 and $1,700 over the next 5 years. Or, Bill can invest $6,100 in project B that promises to pay annual cash flows of $1,500, S1,500, $1,500, $3,700 and $3,900 over the next 5 years. (Hint: For mixed stream cash inflows, calculate cumulative cash inflows on a year-to-year basis unti 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

Payback period = A + B/C

Where,
A = Last period with a negative cumulative cash flow;
B = Absolute value of cash flow at the end of the period A;
C = cash flow during the period after A.

Project A:

Payback period = 2 + 1600/2400 = 2.67 years

Project B:

Payback period = 3 + 1600/3700 = 3.43 years

c. Using payback period method, he should choose project A. since the payback period is less.

d. Yes. payback period doesn't consider the timing of the cashflow and it doesn't consider the cashflows after the payback period.

Year Cashflow (A) Cumulative 0 -6100.00 -6100.00 1 2100.00 -4000.00 2 2400.00 -1600.00 3 2400.00 800.00 4 2100.00 2900.00 5 1700.00 4600.00

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