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 9 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	-36,000	26,000	46,000	17,000
Project B Cash Flow	-46,000	26,000	36,000	66,000

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

• accept both A and B

• accept A, reject B

• accept neither A nor B

• reject A, accept B

Answer 1

The correct answer is:

accept A, reject B

Notes:

The project with the lower discounted payback statistic will be accepted. Also, only one project could be accepted as they are mutually exclusive projects.

Discounted Payback Period =

( Last Year with a Negative Cumulative Cash Flow ) + [( Absolute Value of negative Cumulative Cash Flow in that year)/ Total Present Cash Flow in the following year)]

Project A :

= 1+ (12,146.78899082570 / 38,717.279690262

= 1.31 Years

Note:

	Cash Flow	Discounting Factor ( 9%)	Present Value (Cash Flow * Discounting Factor)	Cumulative Cash Flow (Present Value of Current Year+ Cumulative Cash Flow of Previous Year)
0	-36,000	1	-36,000.00	-36,000.00000000000
1	26,000	0.917431192661	23,853.211009174	-12,146.78899082570
2	46,000	0.841679993267	38,717.279690262	26,570.49069943610
3	17,000	0.772183480061	13,127.119161038	39,697.60986047420

Discounted Payback Period =

( Last Year with a Negative Cumulative Cash Flow ) + [( Absolute Value of negative Cumulative Cash Flow in that year)/ Total Present Cash Flow in the following year)]

Project B :

= 1+22,146.7889908257/30,300.479757596

= 1.73 Years

Note:

	Cash Flow	Discounting Factor ( 9%)	Present Value (Cash Flow * Discounting Factor)	Cumulative Cash Flow (Present Value of Current Year+ Cumulative Cash Flow of Previous Year)
0	-46,000	1	-46,000.00	-46,000.00000000000
1	26,000	0.917431192661	23,853.211009174	-22,146.78899082570
2	36,000	0.841679993267	30,300.479757596	8,153.69076677047
3	66,000	0.772183480061	50,964.109684030	59,117.80045080070