Question

You are considering a project with the following set of cash flows:

	Cash flow
0	-5,500
1	2,000
2	3,000
3	1,000
4	2,000

a. What is the payback period of this project? If the pre-specified cut off is 3 years, should this project be accepted?

b. What is the discounted payback period of this project? If the pre-specified cut off is 3 years, should this project be accepted? The discount rate is 10%.

Answer 1

a.

Year	Cash flows	Cumulative Cash flows
0	(5500)	(5500)
1	2000	(3500)
2	3000	(500)
3	1000	500
4	2000	2500

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+(500/1000)=2.5 years

Hence since payback is less than 3 years;project should be accepted.

2.

Year	Cash flows	Present value@10%	Cumulative Cash flows
0	(5500)	(5500)	(5500)
1	2000	1818.18	(3681.82)
2	3000	2479.34	(1202.48)
3	1000	751.31	(451.17)
4	2000	1366.03	914.86(Approx).

Hence discounted payback=3+(451.17/1366.03)

=3.33 years

Hence since discounted payback is greater than 3 years;project should be rejected.