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Assume a company is going to make an investment of $465,000 in a machine and the following are the cash flows that two different products would bring in years one through four. Option A, Product A Option B, Product B $190,000 $150,000 195,000 175,000 65,000 65,000 25,000 85,000 A. Calculate the payback period of each product. Round your answers to 2 decimal places. Option A, Product A fill in the blank 1 3.4 years Option B, Product B fill in the blank 2 3.8 years B. Which of the two options would you choose based on the payback method

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Answer:

3.6 years

3.88  years

Option A would be chosen because it has a lower payback period than option B

Explanation:

Payback calculates the amount of time it takes to recover the amount invested in a project from it cumulative cash flows

Payback period for option A, Product A

Amount invested =  $-465,000

Amount recovered in year 1 =  $-465,000 + $190,000 = $-275,000

Amount recovered in year 2 = $-275,000 +  $195,000 = $-80,000

Amount recovered in year 3 = $-80,000 + $65,000 = $-15,000

Amount recovered in year 1 = $-15,000 + $25,000 = $10,000

Payback period = 3 years + (15,000) / (25,000) = 3.6 years

Payback period for option b, Product b

Amount invested = $-465,000

Amount recovered in year 1 = $-465,000 + $150,000 = $-315,000

Amount recovered in year 1 = $-315,000 + 175,000 = $-140,000

Amount recovered in year 1 = $-140,000 + 65,000 = $-75,000

Amount recovered in year 1 = $-75,000 + $85,000 = $10,000

Payback period = 3 years + (75,000 / 85,000) = 3.88 years

Option A would be chosen because it has a lower payback period than option B