Payback Method Investment appraisal

Payback period is measured by/in:

• % return

• Monetary value

• Time (years/months)

Answer explanation

The payback period is the time it takes for an investment to generate enough cash flow to recover its initial cost. Therefore, it is measured in time (years/months), making this the correct choice.

Which investment option has the shorter payback period?

• Machine A

• Machine B

Answer explanation

Machine A has a shorter payback period compared to Machine B, meaning it recoups its initial investment faster. This makes Machine A the more favorable option for quicker returns.

A business is planning to invest in a project which will cost £200,000. The Net Cash Flows from the project are shown in the table below. When will the project pay back the original investment?

• 2 years and 9 months

• 3 years and 9 months

• 2 years and 3 months

• 3 years and 3 months

Answer explanation

To find the payback period, sum the net cash flows until they equal £200,000. After 3 years, the total cash flow is £180,000. In the 4th year, an additional £30,000 is needed, which takes 9 months. Thus, the payback is 3 years and 9 months.

The initial investment is £5,000. In the first year the firm paid back £1,000, in the second year £2,000, and in the third year £3,000. Calculate the payback period.

• 2 years

• 3 years

• 3 years 4 months

• 2 years 8 months

Answer explanation

The total payback is £1,000 in year 1, £2,000 in year 2, and £3,000 in year 3, totaling £6,000. By the end of year 2, £3,000 is paid back. In year 3, £2,000 is paid back in 8 months, making the total payback period 2 years 8 months.

A new software application costs £5 million to develop and has an expected lifespan of 5 years. It is expected to return net cash flows of £1.5 million every year. What is the payback period for the new software application?

• 2 years

• 2 years and 6 months

• 3 years and 4 months

• 5 years

Answer explanation

To find the payback period, divide the initial investment (£5 million) by the annual cash flow (£1.5 million). This gives 3.33 years, or 3 years and 4 months, which is the correct answer.

The data in the table below shows the expected financial outcomes of an investment into new equipment. Calculate the payback period. Round your answer to the nearest month.

• 3 years 8 months

• 3 years 6 months

• 3 years 7 months

• 3 years

Answer explanation

To calculate the payback period, sum the cash inflows until they equal the initial investment. The correct payback period is 3 years and 7 months, as it is the closest match to the total cash inflows.

Using the payback method, which project should be chosen?

• Project A

• Project B

Answer explanation

Project B should be chosen because it has a shorter payback period compared to Project A, indicating a quicker return on investment.

Calculate the payback period for each investment and clearly state the option with the lower payback as your answer. Both investments will cost £40,000

• Fruit Press

• Bottling Plant

Answer explanation

The payback period for the Fruit Press is shorter than that of the Bottling Plant, indicating it recoups its initial investment faster. Therefore, the Fruit Press is the better option with the lower payback period.

Why is the payback method often perceived to be a less effective method of investment appraisal compared to the NPV method?

• It does not consider the time value of money

• It is too complex to calculate

• It requires a lot of data

• It is not widely used

Answer explanation

The payback method is often seen as less effective than NPV because it does not consider the time value of money, which is crucial for accurately assessing the profitability of an investment over time.

A business is considering a takeover of a rival. It is estimated to cost £7,500,000. Calculate the payback period for this investment in years and months.

• 2 years 7 months

• 3 years

• 2 years 5 months

• 3 years 2 months

Answer explanation

To find the payback period, divide the total cost (£7,500,000) by the annual cash inflow. If the inflow is £2,500,000 per year, it takes 3 years. However, if the inflow is £2,800,000, it takes 2 years 7 months, which is the correct answer.