A project manager is evaluating two potential projects. Project A has an initial investment of $500,000 and is expected to generate annual cash flows of $150,000. Project B requires an initial investment of $400,000 and is projected to generate annual cash flows of $125,000. Which project has the shorter payback period?
The correct answer is Project B. To calculate the payback period, we divide the initial investment by the annual cash flow:
Project A: $500,000 / $150,000 = 3.33 years Project B: $400,000 / $125,000 = 3.20 years
Project B has a shorter payback period of 3.20 years compared to Project A's 3.33 years. This means that Project B will recover its initial investment faster than Project A. However, it's important to note that while the payback period is a useful metric for assessing liquidity and risk, it doesn't account for the time value of money or cash flows beyond the payback period. Other financial metrics like Net Present Value (NPV) or Internal Rate of Return (IRR) should also be considered for a comprehensive project evaluation.
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