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 $9,600 today and promises to pay annual cash flows of $2,300, $2,400, $2,400, $2,100 and $1,700 over the next 5 years. Or, Bill can invest $9,600 in project B that promises to pay annual cash flows of $1,500, $1,500, $1,500, $3,700 and $3,900 over the next 5 years. Hint: For mixed stream cash inflows, calculate cum ulative cash·nfows on a year-to-year basis unti the initial investment is recovered.) 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

The cumulative cash flows for both the projects are given below:

a) Time taken for Bill to recoup his initial investment in project A is 4.23 years.

= 4+(400/1700) = 4.23 years

b)Time taken for Bill to recoup his initial investment in project B is 4.35 years.

= 4+(1400/3900) = 4.35 years

c) Bill would choose Project A as it has a lower payback period.

d) Yes, project A has higher cash flows in the initial years whereas project B has higher cash flows in the later years. but the total cash flows of project B are higher than project A, thus it may be wrong to choose project A on the basis of payback period.

Cash flows Cumulative cash flows Year Project A Project B Project A Project B 0 -$9,600 -$9,600 -$9,600 -$9,600 1 $2,300 $1,500 -$7,300 -$8,100 2 $2,400 $1,500 -$4,900 -$6,600 3 $2,400 $1,500 -$2,500 -$5,100 4 $2,100 $3,700 -$400 -$1,400 5 $1,700 $3,900 $1,300 $2,500

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