Question

Two new wind-farm tower projects are proposed for a small company that installs them in south western Pennsylvania. Project A will cost $250,000 to complete and is expected to have an annual net cash flow of $75,000. Project B will cost $150,000 to complete and should generate annual net cash flows of $52,000. As a small company, the owner and senior management team are very concerned about their cash flow. Use the payback period method and determine which project is better from a cash flow standpoint. Show your work and include any formulas used to calculate PP.

Answer 1

Explanation:

The payback period is the time to regain the cost of the investment or DRCI. It is a risk criterion that measures the time needed for the discounted sum of the forecast cash flows to allow the recovery of the cost incurred by the investment. However, the shorter the payback period, the lower the risks associated.

Mathematically;

Payback period = Cost of the investment / Annual Net Cash Flow

From the given question:

For project A;

Cost of investment = $250,000

Annual net Cash Flow = $75000

The payback period for Project A = $250,000 / $75,000

The payback period for Project A = 3.33

For project B;

Cost of investment = $150,000

Annual net Cash Flow = $52000

The payback period for Project A = $150,000 / $52,000

The payback period for Project A = 2.88

Thus, from the calculation, we can deduce that project B is better than project A because there fewer risks associated with it because it has a shorter payback period compared to project A.