Payback Period Comparison
Compare two projects using the payback period method.
Problem Scenario
Project A costs $8,000 with annual CFs of $3,000. Project B costs $12,000 with CFs of $5,000. Cutoff is 3 years.
Given Data
Requirements
- Calculate payback for each
- Which meets the 3-year cutoff?
Solution
Step 1:
Project A payback = 8,000 / 3,000 = 2.67 years.
Step 2:
Project B payback = 12,000 / 5,000 = 2.40 years.
Step 3:
Both meet the 3-year cutoff. Project B pays back faster.
Final Answer
A = 2.67 years, B = 2.40 years. Both pass, but B is faster.
Key Takeaways
- ✓Payback ignores cash flows after cutoff
- ✓Use alongside NPV for better decisions
Common Errors to Avoid
- ✗Choosing based on payback alone
- ✗Ignoring TVM (discounted payback corrects this)
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Common questions about this problem type
Not necessarily. A longer payback project might have much higher NPV from later cash flows.
It ignores the time value of money and all cash flows after the cutoff. A project that pays back in 2 years but generates large cash flows in years 3-10 might be rejected by payback alone but accepted by NPV.