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PAYBACK PERIOD EXAMPLE PROBLEMS WITH SOLUTIONS
When evaluating investment opportunities, one of the key metrics used by businesses is the payback period. The payback period is the amount of time it takes for an investment to generate enough cash flow to recover the initial investment cost. In this article, we will explore payback period example problems with solutions to help you understand how this metric is calculated and its significance in decision-making.
Calculating Payback Period
The payback period is calculated by dividing the initial investment cost by the annual cash inflows generated by the investment. The formula for calculating payback period is as follows:
Payback Period = Initial Investment Cost / Annual Cash Inflows
Example Problem 1
Let’s consider a hypothetical investment opportunity where a company is considering investing $50,000 in a new project. The project is expected to generate annual cash inflows of $10,000.
. To calculate the payback period for this investment, we can use the formula mentioned above:
Payback Period = $50,000 / $10,000 = 5 years
Solution
Based on the calculation, the payback period for this investment is 5 years. This means that it will take 5 years for the company to recoup the initial investment cost through the cash inflows generated by the project.
Example Problem 2
Now, let’s consider another scenario where a company is evaluating an investment of $100,000 in a new product line. The expected annual cash inflows from this investment are $25,000. Using the payback period formula, we can calculate the payback period as follows:
Payback Period = $100,000 / $25,000 = 4 years
Solution
Based on the calculation, the payback period for this investment is 4 years. This indicates that the company will recover the initial investment cost in 4 years through the cash inflows generated by the new product line.
Significance of Payback Period
- The payback period helps businesses assess the time it takes to recover their initial investment, providing insights into the project’s profitability and risk.
- Shorter payback periods are generally preferred as they indicate quicker returns on investment and lower risk.
- Longer payback periods may signal higher risk and lower profitability, requiring careful evaluation before making investment decisions.
Conclusion
In conclusion, the payback period is a valuable metric used by businesses to evaluate investment opportunities. By understanding how to calculate the payback period and analyzing example problems with solutions, businesses can make informed decisions about their investments. It is essential to consider not only the payback period but also other financial metrics and qualitative factors when assessing investment opportunities.
For further reading on payback period and other financial metrics, you can refer to this Investopedia article.
