Project A Project B Time 0 -10,000 -5,000
Time 1 4,000 3,000
Time 2 3,000 2,000
Time 3 10,000 2,000
If WiseGuy Inc. uses payback period rule to choose projects, which of the projects (Project A or Project B) will rank highest?
a) Project A
b) Project B
c) Project A and B have the same ranking
d) Cannot calculate a payback period without a discount rate

b) Project B

Explanation:

Payback period works by checking how long it will take a project to pay back the initial amount invested in it. Project A.

Project A

Payback Period = Year before Payback happens + Amount left till payback/Cash inflow in year of payback

= Time 1 + Time 2

= 4,000 + 3,000

= $7,000

This amount is not enough to cover the investment of $10,000 so the investment will be paid in Time 3 and remains $3,000.

= 2 + 3,000/10,000

= 2.3 Times

Project B

= Time 1 + Time 2

= 3,000 + 2,000

= $5,000

At the end of Time 2, Project B has paid off its initial investment of $5,000. Its Payback period is 2 Times. This is lower than Project A so this project will rank higher.

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