Using the same cash flows as above, what is the payback period?

• A. 1.89 years
• B. 1.50 years
• C. 2.00 years
• D. 1.25 years

Answer: (A)

Payback period is the time it takes to recover the initial investment from the project’s cash inflows. You add up the cash inflows year by year until they equal the initial outlay. If the recovery occurs partway through a year, you interpolate to find the fraction of that year needed. The formula is: payback period = full years before recovery + (amount still needed at the end of that year) / cash flow in the recovery year. Here, that calculation yields 1.89 years, meaning after one full year you haven’t yet recovered everything, and the remaining amount is recovered during the second year, about 89% of that year's cash inflow. Remember, this method ignores the time value of money and any cash flows after the payback point.