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 10 percent, and that the maximum allowable payback and discounted payback statistic for the project are 2 and 3 years, respectively.

Time	0	1	2	3	4	5	6
Cash Flow	-1,050	150	450	650	650	250	650

Use the payback decision rule to evaluate this project; should it be accepted or rejected?

Answer 1

Calculation for payback
	Time	Cash Flow	Cumulative cash flow
	0	-1,050	-1,050
	1	150	-900
	2	450	-450
	3	650	200
	4	650	850
	5	250	1,100
	6	650	1,750
	Pay back period = A + B/C
	In the above formula,
	A is the last period with a negative cumulative cash flow;
	B is the absolute value of cumulative cash flow at the end of the period A;
	C is the total cash flow during the period after A
	Payback period = 2 + (450/650)
		2.69	Years
Calculation for discounted payback
	Time	Cash Flow	PVF at 10%	Present Value	Cumulative PV
	0	-1,050	1	$ (1,050.00)	$ (1,050.00)
	1	150	0.90909091	$       136.36	$     (913.64)
	2	450	0.82644628	$       371.90	$     (541.74)
	3	650	0.7513148	$       488.35	$       (53.38)
	4	650	0.68301346	$       443.96	$       390.58
	5	250	0.62092132	$       155.23	$       545.81
	6	650	0.56447393	$       366.91	$       912.72
	Payback period = 3 + (53.38/443.96)
		3.12	Years
Decision:	Since payback period and discounted payback , both are more than the prescribed
	payback and discounted payback of 2 & 3 yrs, so it is not acceptable.