Question

You are trying to decide whether to accept or reject a project. The project will generate a cash flow of $15,000 in year one; $25,000 in year two; $20,000 in year three; and $4,000 in year four. The project costs $40,000 initially. The firm has a weighted average cost of capital of 8%. Your firm generally accepts projects that payback in three years or less. What is the discounted payback of the project? Should you accept or reject the project?

Answer 1

As cash flow payback is falling before 3 years, Payback period is 2 years we can accept the project.

In case of discounted payback period we are getting 2.29 years. It is falling before 3 years again. We can accept the project based on discounted payback also.

		Rate = R =	8%
Year	Cash flows	Cumulative cash flow	Discount factor = Df = 1/(1+R)^Year	Present value = Df x Cash flows	Cumulative discounted cash flow
0	-$40,000.00	-$40,000.00	1.0000	-$40,000.00	-$40,000.00
1	$15,000.00	-$25,000.00	0.9259	$13,888.89	-$26,111.11
2	$25,000.00	$0.00	0.8573	$21,433.47	-$4,677.64
3	$20,000.00	$20,000.00	0.7938	$15,876.64	$11,199.00
4	$4,000.00	$24,000.00	0.7350	$2,940.12	$14,139.12
5
6
7
8
			Total of Present Value = NPV=	$14,139.12

Payback period = A + |B|/C                      

A = Last period with a negative cumulative cash flow                     

|B| = Absolute value of cumulative cash flow at end of period A               

C = Total cash flow during the period after A                     

                            

Payback period = 1 + |-25000|/25000 = 2 years

-------------------------

Discounted Payback period = A + |B|/C                              

A = Last period with a negative discounted cumulative cash flow                                           

|B| = Absolute value of discounted cumulative cash flow at end of period A                                          

C = Discounted cash flow during the period after A                                      

                                          

Discounted Payback period = 2 + |-4677.64|/15876.64 = 2.29 years