What is the payback period for a project with an initial investment of $220,000 that provides an annual cash inflow of $20,000 for the first three years and $60,000 per year for years four and five, and $85,000 per year for years six through eight?
Payback period is one of the capital budgeting methods. It tells us the number of years it takes to recover the initial investment of the project. The major drawback of this method is that it does not take into account time value of money. Cash flows taking place after payback period are ignored.
Answer and Explanation:
Cash outflow = $220,000
Total cash flows in first five years = $20,000 * 3 + $60,000 * 2 = $180,000
Cash outflow left to be recovered = $220,000 - $180,000 = $40,000
Now, using unitary method we will calculate the time it takes to recover $40,000
Time required to get cash flow of $40,000 = $40,000 / $85,000 = 0.47
Thus, it takes 5.47 years to recover $220,000.
Payback period = 5.47 years
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from Financial Accounting: Help and ReviewChapter 5 / Lesson 24