In: Finance
Suppose your firm is considering investing in a project with the cash flows shown below, that the required rate of return on projects of this risk class is 8 percent, and that the maximum allowable payback and discounted payback statistics for the project are 3.5 and 4.5 years, respectively. Time: 0 1 2 3 4 5 6 Cash flow: ?$5,000 $1,200 $2,400 $1,600 $1,600 $1,400 $1,200 Use the discounted payback decision rule to evaluate this project.
Payback period is the time in which initial cash outflow is expected to be recovered from the cash inflows generated by project. The projects having Payback period earlier than Payback Period allowed will be accepted.
Year | Cash Flow | Cumulative Cash Flow |
0 |
($5,000) | ($5,000) |
1 | $1,200 | ($3,800) |
2 | $2,400 | ($1,400) |
3 | $1,600 | $200 |
Now Payback Period through Interpolation will be :-
Since this Project's Payback Period is lesser than Payback period allowed, this Project will be accepted.
Discounted Payback Period refers to the period within which the present values of cash inflows completely recover present value of cash outflows. It has plugged the deficiency of Payback Period of ignoring time value of money. It is computed by calculating cumulative present value of cash inflows till it becomes equal to present value of cash outflows. Projects having Discounted Payback Period lesser than Discounted Payback Period allowed will be accepted.
Year | Cash Flow | Present Value Factor | Discounted Cash Flow | Cumulative Discounted Cash Flow |
0 | ($5,000) | 1.0000 | ($5,000) | ($5,000) |
1 | $1,200 | 0.9259 | $1,111.08 | ($3,888.92) |
2 | $2,400 | 0.8573 | $2,057.52 | ($1,831.4) |
3 | $1,600 | 0.7938 | $1,270.08 | ($561.32) |
4 | $1,600 | 0.7350 | $1,176 | $614.68 |
Now Discounted Payback Period through Interpolation will be :-
Since this Project's Discounted Payback Period is lesser than Payback period allowed, this Project will be accepted.