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	-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

Answer 1

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.