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You are considering two mutually exclusive projects. Project A has cash flows of −$72,000, $21,400, $22,900, and $56,300 for Years 0 to 3, respectively. Project B has cash flows of −$81,000, $20,100, $22,200, and $74,800 for Years 0 to 3, respectively. Both projects have a required 2.5-year payback period. Should you accept or reject these projects based on payback analysis?

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Answer:

Choose Project A whose payback is 2.492 years and therefore falls within the 2.5 year required payback period.

Explanation:

Project A    

Year   Cash-flow   Balance

0    (72,000)    (72,000)

1    21,400     (50,600)

2    22,900     (27,700)

3    56,300     28,600  

[tex]Payback = YearsWithNegativeCumulativeCashflowBalance + \frac{-LastNegativeBalance}{CashInflowfollowingYear} [/tex]

[tex]= 2years + \frac{-(-27,700}{56300}=2.492 years[/tex]

Project B      

Year  Cash-flow          Balance  

0    (81,000)    (81,000)

1    20,100     (60,900)

2    22,200     (38,700)

3    74,800     36,100  

[tex]Payback = YearsWithNegativeCumulativeCashflowBalance + \frac{-LastNegativeBalance}{CashInflowfollowingYear} [/tex]

[tex]= 2years + \frac{-(-38,700}{74,800}=2.517 years[/tex]

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