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This project costs \$500. What is the payback period for this investment?

The initial cost is \$500. After the first two years, the cash flows total \$300. After the third year, the total cash flow is \$800, so the project pays back sometime between the end of Year 2 and the end of Year 3. Because the accumulated cash flows for the first two years are \$300, we need to recover \$200 in the third year. The third-year cash flow is \$500, so we will have to wait \$200/500 = .4 year to do this. The payback period is thus 2.4 years, or about two years and five months.

Now that we know how to calculate the payback period on an investment, using the payback period rule for making decisions is straightforward. A particular cutoff time is selected, say, two years, and all investment projects that have payback periods of two years or less are accepted, and all of those that pay off in more than two years are rejected.

Table 9.1 illustrates cash flows for five different projects. The figures shown as the Year 0 cash flows are the costs of the investments. We examine these to indicate some peculiarities that can, in principle, arise with payback periods.

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

IV. Capital Budgeting

9. Net Present Value and Other Investment Criteria