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 11 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	-33,000	23,000	43,000	14,000
Project B Cash Flow	-43,000	23,000	7,000	63,000

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

• accept both A and B

• reject A, accept B

• accept A, reject B

• accept neither A nor B

Answer 1

Payback Period for PROJECT-A

Year	Annual cash flows ($)	Cumulative Annual cash flows ($)
0	-33,000	-33,000
1	23,000	-10,000
2	43,000	33,000
3	14,000	47,000

Payback Period for Project-A = Years before full recover + (Unrecovered cash inflow at start of the year/cash flow during the year)

= 1.00 Years + ($10,000 / $43,000)

= 1.00 Years + 0.23 Years

= 1.23 Years

Payback Period for PROJECT-B

Year	Annual cash flows ($)	Cumulative Annual cash flows ($)
0	-43,000	-43,000
1	23,000	-20,000
2	7,000	-13,000
3	63,000	50,000

Payback Period for Project-B = Years before full recover + (Unrecovered cash inflow at start of the year/cash flow during the year)

= 2.00 Years + ($13,000 / $63,000)

= 2.00 Years + 0.21 Years

= 2.21 Years

DECISION

“Accept A, reject B”, The firm should Accept A, reject B, since the Payback Period for the Project-A (1.23 Years) is less than the maximum allowable payback period of 2.00 Years and the Payback period Project-B (2.21 Years) is greater than the maximum allowable payback period.