Question

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 7 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: −$5,100 $1,240 $2,440 $1,640 $1,560 $1,440 $1,240

Use the payback decision rule to evaluate this project.

How many years will it take?

Answer 1

Time	Cash flows	Discount factor at 7%	Discounted cash flow	Cumulative cash flow	Discounted cumulative cash flow
0	-5100	1	-5100.00	-5100.00	-5100.00
1	1240	0.9346	1158.88	-3860.00	-3941.12
2	2440	0.8734	2131.19	-1420.00	-1809.93
3	1640	0.8163	1338.73	220.00	-471.20
4	1560	0.7629	1190.12	1780.00	718.91
5	1440	0.7130	1026.70	3220.00	1745.61
6	1240	0.6663	826.26	4460.00	2571.88
	Payback =	2.87	years
	Discounted Payback =	3.40	years

From the above table we can see that payback period is less than 3.5 years and discounted payback period is less than 4.5 years. Therefore, as per the payback decision rule this project can be accepted.

Formulas used in the above table:

Where,
PB = Payback period

Where,
DPB = Discounted payback period

Excel formulas used: