Question

Suppose your firm is considering two mutually exclusive, required projects with the cash flows shown below. The required rate of return on projects of both of their risk class is 8 percent, and that the maximum allowable payback and discounted payback statistic for the projects are 2 and 3 years, respectively. Time: 0 1 2 3 Project A Cash Flow -25,000 15,000 35,000 6,000 Project B Cash Flow -35,000 15,000 25,000 55,000 Use the discounted payback decision rule to evaluate these projects; which one(s) should be accepted or rejected?

reject A, accept B

accept both A and B

accept A, reject B

accept neither A nor B

Answer 1

A:

Year	Cash flows	Present value@8%	Cumulative Cash flows
0	(25000)	(25000)	(25000)
1	15000	13888.89	(11,111.11)
2	35000	30,006.86	18895.75
3	6000	4762.99	23658.74(Approx)

Hence discounted Payback period=Last period with a negative cumulative cash flow+(Absolute value of cumulative cash flows at that period/Cash flow after that period).

=1+(11,111.11/30006.86)

=1.37 years(Approx)

B:

Year	Cash flows	Present value@8%	Cumulative Cash flows
0	(35000)	(35000)	(35000)
1	15000	13888.89	(21,111.11)
2	25000	21433.47	322.36
3	55000	43660.77	43983.13(Approx)

Hence discounted Payback period=Last period with a negative cumulative cash flow+(Absolute value of cumulative cash flows at that period/Cash flow after that period).

=1+(21,111.11/21433.47)

=1.98 years(Approx)

Hence since projects are mutually exclusive;only A must be accepted having lower discounted payback and B rejected.

Hence the correct option is C.