A contractor is considering purchasing a $75,000 piece of equipment. The equipment will generate additional annual revenue of $25,000 and additional annual costs of $8,000. What is the simple payback period?
Correct Answer
B) 4.4 years
Payback period = Initial Investment ÷ Annual Net Cash Flow. Net cash flow = $25,000 - $8,000 = $17,000. $75,000 ÷ $17,000 = 4.4 years.
Why This Is the Correct Answer
The simple payback period formula is Initial Investment ÷ Annual Net Cash Flow. First, we calculate the net annual cash flow by subtracting annual costs from annual revenue: $25,000 - $8,000 = $17,000. Then we divide the initial investment by this net cash flow: $75,000 ÷ $17,000 = 4.4 years. This represents how long it takes to recover the initial investment through net positive cash flows.
Why the Other Options Are Wrong
Option C: 3.0 years
This answer incorrectly uses only the annual costs ($8,000) as the divisor: $75,000 ÷ $8,000 = 9.375 years, rounded to 9.4 years.
Option D: 8.8 years
This answer incorrectly uses only the annual costs ($8,000) instead of net cash flow, or makes an error in the division calculation.
Memory Technique
Remember 'PIN' - Payback = Investment ÷ Net cash flow. Always subtract costs from revenue first to get the NET amount.
Reference Hint
Look up 'Capital Budgeting' or 'Equipment Investment Analysis' in construction management or business finance chapters of your reference materials.
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