Question

In: Finance

Suppose your firm is considering two mutually exclusive, required projects with the cash flows shown below....

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 -38,000 28,000 48,000 19,000
  Project B Cash Flow -48,000 28,000 38,000 68,000


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

reject A, accept B

accept both A and B

accept A, reject B

accept neither A nor B

Solutions

Expert Solution

A:

Year Cash flows Present value@11% Cumulative Cash Flows
0 (38000) (38000) (38000)
1 28000 25225.23 (12774.77)
2 48000 38957.88 26183.11
3 19000 13892.64 40075.75(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+(12774.77/38957.88)

=1.33 years.

B:

Year Cash flows Present value@11% Cumulative Cash Flows
0 (48000) (48000) (48000)
1 28000 25225.23 (22774.77)
2 38000 30841.65 8066.88
3 68000 49721.01 57787.89(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+(22774.77/30841.65)

=1.74 years.

Hence since projects are mutually exclusive;A must be accepted and B rejected as A has lower discounted payback period as compared to B.


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