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 -21,000 11,000 31,000 2,000 Project B Cash Flow -31,000 11,000 21,000 51,000 Use the discounted payback decision rule to evaluate these projects; which one(s) should it be accepted or rejected? accept A, reject B accept neither A nor B reject A, accept B accept both A and B

Answer 1

A:

Year	Cash flows	Present value@9%	Cumulative Cash flows
0	(21000)	(21000)	(21000)
1	11000	10091.74	(10908.26)
2	31000	26092.08	15183.82
3	2000	1544.37	16728.19(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+(10908.26/26092.08)=1.42 years(Approx)

B:

Year	Cash flows	Present value@9%	Cumulative Cash flows
0	(31000)	(31000)	(31000)
1	11000	10091.74	(20908.26)
2	21000	17675.28	(3232.98)
3	51000	39381.36	36148.38(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+(3232.98/39381.36)=2.08 years(Approx)

Hence since projects are mutually exclusive;A must be selected and B rejected having lower discounted payback period.