Question 8.5: Determine the payback period for a proposed investment as fo......
Determine the payback period for a proposed investment as follows:
| End of Year | 0 | 1 | 2 | 3 | 4 | 5 |
| Cash Flow, $1000 | -50 | 10 | 12 | 15 | 18 | 20 |
The sum of the first three yearly cash inflows, $37 000, is less than the initial investment, $50 000; but the sum of the first four yearly cash inflows, $55 000, exceeds the initial investment. Hence the payback period will be somewhere between 3 and 4 years. Linear interpolation yields
PBP ≈ 3 + \frac{\$50 000 – \$37 000}{\$55 000 – \$37 000} (4 – 3) = 3.72 years
Because it ignores the time value of money, the payback method should not be used in place of the other methods discussed above. On the other hand, the payback method is valuable for a secondary analysis, when the NPV or ROR is used as the primary method. As will be further discussed in Chapter 9, there are many practical examples where an investment is sought with a high rate of return and a sufficiently short payback period.