Zulfiqar Hasan
This example will enable you to calcualte and to take decision in capital budgeting. Payack Period (PBP), Net Present Value (NPV) and Profitability Index (PI) are calculated here for two projects.

Problem:

Use data from the following table and Calculate payback period of both projects if Target Payback Period is 2.9 Years. Whcih projects should be selected if they are Independent? If they are mutually exclusive?

Solutions:
a. We apply the following formula to calculate the Payback Period

${\color{Blue}&space;PBP&space;=a+\left&space;(&space;\frac{b-c}{d{\color{Blue}&space;}}&space;\right&space;)}$
a = Number of Year before Full recovery year
b = Initial investment
c. Cumulative cash flow at year "a"
d = Actual Cash Flow at full recovery Year

 Project X 0 1 2 (a) 3 (Full Recovery Year) 4 CF -10000 (b) 6500 3000 3000 (d) 1000 Cumulative Cash Flow 6500 9500 (c) 12500 13500

 Project Y 0 1 2 (a) 3 (Full Recovery Year) 4 -10000 3500 3500 3500 (d) 3500 Cumulative Cash Flow 3500 7000 (c) 10500 14000

Payback Period of Project X:

${\color{Blue}&space;PBP&space;=2+\left&space;(&space;\frac{10000-9500}{3000{\color{Blue}&space;}}&space;\right&space;)}$
= 2.17 Years

Payback Period of Project Y:

${\color{Blue}&space;PBP_{Y}&space;=2+\left&space;(&space;\frac{10000-7000}{3500{\color{Blue}&space;}}&space;\right&space;)}$
= 2.86 Years

Decision Under Payback Period:
Independent Project: As actual (calculated) payback period is lower than the Target Paback period in both projects, both project X and Project Y can be selected if they are independent.

Mutualy Exclusive Project: Project under lower payback period should be selected if they are mutually exclusive project. Here, Project X should be selected.

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