Question

Assume a \(40,000 investment and the following cash flows for two alternatives:

Year	Investment X	Investment Y
1	\)6,000	$15,000
2	8,000	20,000
3	9,000	10,000
4	17,000	--
5	20,000	--

Which of the alternatives would you select under the payback method?

Short answer

Answer

The business entity must select Investment Y because it is having less payback period than investment X.

Step-by-step solution

Definition of Payback Period

Payback period is the method or technique which is used under the capital budgeting method to determine the time taken by the investment made by the company to record the whole investment.

Alternative to be selected under the payback period

1. Investment X will get fully recovered in 4 years.

2. Investment Y:

3. $$\begin{gathered} Paybackperiod=Periodbeforefullrecovery+\frac{Amountrecoveredinlastperiod}{Cashflowinlastperiod} \\ =2+\frac{\$5,000}{\$10,000} \\ =2+0.5 \\ =2.5years \end{gathered}$$

According to the payback period the business entity must select investment Y.

Working note: Calculation of accumulated depreciation

Year	Cash inflows of investment X	Cash inflows of investment X	Cash inflows of investment Y	Accumulated cash flow of investment Y
1	$6,000	$6,000	$15,000	$15,000
2	8,000	$14,000	20,000	$35,000
3	9,000	$23,000	10,000
4	17,000	$40,000	--
5	20,000		--