ITPEC FE Morning October 2018 Question 79
Company Z is planning to start a new project of which the initial investment is 100 million dollars. It is expected to generate cash as shown in the following table. What is the payback period of the new project?
Cash flow in million dollars
Explanation
3.2 years — add the cash flows until they cover the 100 million invested, then take the fraction of the year in which the rest comes in.
After 3 years, 100 − 90 = 10 million is still unrecovered. Year 4 brings in 50, spread evenly, so the remaining 10 takes 10 ÷ 50 = 0.2 year. Payback period: 3 + 0.2 = 3.2 years. The (100) in year 0 is the investment, an outflow.
Answer (b)
Why not others:
- •(a) 3.0 — only 90 million is back after three years, 10 short of the investment
- •(c) 3.5 — takes half of year 4, as if 25 million were still unrecovered; only 10 of year 4's 50 is needed
- •(d) 4.0 — counts year 4 as a whole year, although the investment is recovered early in it
Key rule: Payback period = the whole years before recovery + (amount still unrecovered ÷ cash flow of the year in which recovery happens).
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