Assume a $4,000 investment and the following cash flows for two alternatives.
Year Investment X Investment Y
1 $1,000 $1,300
2 800 2,800
3 700 100
4 1,900
5 2,000
a. Under the payback method, which investment should be chosen? (Show your work/analysis/calculations for each investment).
b. Why do other methods allow for a better analysis?
How much will Pauline pay in interest if she takes out a simple interest loan with a principal of $3,900 at 7.2% for three years?
Calculate the return on investment in dollars and as a percentage for an investment that you purchase for $500 and sell for $600.
a. To determine which investment should be chosen using the payback method, we need to calculate how long it takes for each investment to recover the initial investment of $4,000.
For Investment X:
Year 1: $1,000
Year 2: $800
Year 3: $700
Year 4: $1,900
The cumulative cash flows for Investment X are as follows:
Year 1: $1,000
Year 2: $1,800 ($1,000 + $800)
Year 3: $2,500 ($1,800 + $700)
Year 4: $4,400 ($2,500 + $1,900)
Investment X would take 3 years to recover the initial investment of $4,000.
For Investment Y:
Year 1: $1,300
Year 2: $2,800
Year 3: $100
The cumulative cash flows for Investment Y are as follows:
Year 1: $1,300
Year 2: $4,100 ($1,300 + $2,800)
Year 3: $4,200 ($4,100 + $100)
Investment Y would take 3 years to recover the initial investment of $4,000.
Since both investments take the same amount of time to recover the initial investment, the payback method does not provide a clear choice. It only helps in identifying the length of the payback period.
b. Other methods, such as the net present value (NPV) or internal rate of return (IRR), allow for a better analysis because they consider the time value of money and provide a more comprehensive evaluation of an investment.
The NPV method calculates the present value of all the cash flows, including the initial investment, using a discount rate that represents the opportunity cost of capital. It determines whether the investment is expected to generate positive or negative value. The investment with a higher NPV is preferred.
The IRR method calculates the discount rate at which the net present value of cash flows becomes zero. It represents the return rate at which the investment breaks even. The investment with a higher IRR is generally considered more attractive.
Both NPV and IRR take into account the timing and size of cash flows, allowing for a more accurate analysis of investment decisions. They also consider the time value of money, which is an essential factor in the evaluation of investments over the long term.