A firm is evaluating a proposal which has an initial investment of $45,000 and has cash flows of $5,000 in year 1, $20,000 in year 2, $15,000 in year 3, and $10,000 in year 4. The payback period of the project is:

3.5years

Explanation:

Payback is a risk evaluation practice that involves the calculation of the time required to recover an amount in a particular business opportunity or an asset, expressed in years or fraction of years.

It is calculated either by averaging method or subtraction method.

Using the subtraction method for the question

Investment amount = 45,000

Year 1 $5,000

Year 2 $20000

Year 3 $15,000

Year 4 $10,000

Total $50,000

The investment amount is recovered midway into year 4

3.5 years.

Explanation:

Payback period of a project is the time it takes a project it pay back the initial amount that is invested in it. This is an important consideration for investors because it is used to ascertain when investment will return and profits above initial investment can be made.

In this scenario the project has cash flows of $5,000 in year 1, $20,000 in year 2, $15,000 in year 3, and $10,000 in year 4.

For the first 3 years cash flow is 5,000 + 20,000 + 15,000 = $40,000

Now we need $5,000 from the fourth year to meet initial investment.

That is $10,000 : 2 or equivalent of half a year in the fourth year.

Therefore it takes 3.5 years for the project to pay back initial investment.