Question

1.      Suppose your firm is considering two mutually exclusive, required projects with the cash flows shown as follows. The required rate of return on projects of both of their risk class is 8 percent, and the maximum allowable payback and discounted payback statistic for the projects are two and three years, respectively.

Time	0	1	2	3
Project A Cash Flow	?20,000	10,000	30,000	1,000
Project B Cash Flow	?30,000	10,000	20,000	50,000

Use the discounted payback decision rule to evaluate these projects; which one(s) should be accepted or rejected?

A.      ACCEPT BOTH A AND B

B.       ACCEPT NEITHER A NOR B

C.       ACCEPT A, REJECT B

D.      REJECT A, ACCEPT B

Answer 1

A:

Year	Cash flows	Present value@8%	Cumulative cash flows
0	(20000)	(20000)	(20000)
1	10000	9259.26	(10740.74)
2	30000	25720.16	14979.42
3	1000	793.83	15773.25(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+(10740.74/25720.16)

=1.42 years(Approx)

B:

Year	Cash flows	Present value@8%	Cumulative cash flows
0	(30000)	(30000)	(30000)
1	10000	9259.26	(20740.74)
2	20000	17146.78	(3593.96)
3	50000	39691.61	36097.65(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).
=2+(3593.96/39691.61)

=2.09 years(Approx)

Hence both the projects have discounted payback less than 3 years;however since projects are mutually exclusive;A must be accepted while B rejected having lower payback.((C).