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A contractor is evaluating an investment in a new trenching machine that costs $80,000. It is expected to generate additional net cash inflows of $20,000 per year. What is the payback period for this investment?
- A2 years
- B4 years
- C3 years
- D5 years
Show answer & explanationAnswer & explanation
Correct answer: B. 4 years
The payback period is calculated as the Initial Investment divided by the Annual Net Cash Inflow. So, $80,000 / $20,000 per year = 4 years.
Why the other options are wrong
- A. This would be the result if the initial investment was $40,000.
- C. This would be the result if the initial investment was $60,000.
- D. This would be the result if the initial investment was $100,000.
Payback Period
The payback period is the amount of time required for an investment to generate enough cash flow to recover its initial cost. It is a simple capital budgeting technique.
- Formula: Initial Investment / Annual Cash Inflow (for even cash flows)
- Measures investment liquidity and risk
- Generally, shorter payback periods are preferred
Memory trick: Payback Period: Initial Cost 'Divided' by annual cash, to see how 'Quickly' you get your money back.