91Ó°ÊÓ

Payback period is the matric used by the company under the capital budgeting methods which help them to selects the investment based on the time taken by the investment to cover the amount of potential investment through cash inflows.

Investment A:

$$\begin{gathered} Paybackperiod=Periodbeforefullrecovery+\frac{Amountrecoveredinlastperiod}{Cashflowinperiod} \\ =3+\frac{\$10,000}{\$19,000} \\ =3+0.5 \\ =3.5years \end{gathered}$$

Investment B:

$$\begin{gathered} Paybackperiod=Periodbeforefullrecovery+\frac{Amountrecoveredinlastperiod}{Cashflowinperiod} \\ =2+\frac{\$10,000}{\$28,000} \\ =2+0.4 \\ =2.4years \end{gathered}$$

The business entity must select project B.

Working note:

The answer would not change under the payback method if the cash inflow in the 5th year were $25,000,000 instead of $25,000 because the initial investment cost will be covered in 3.5 years. Therefore, a change in the cash inflow of the 5th year would not affect the answer.