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 12 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 -1,150 30 570 770 770 370 770 Use the discounted payback decision rule to evaluate this project; should it be accepted or rejected? Multiple Choice 3.33 years, reject 2.67 years, accept 2.75 years, accept 3.25 years, reject

Answer 1

Year	Cash flows	Present value@12%	Cumulative Cash flows
0	(1150)	(1150)	(1150)
1	30	26.79	(1123.21)
2	570	454.40	(668.81)
3	770	548.07	(120.74)
4	770	489.35	368.61
5	370	209.95	578.56
6	770	390.11	968.67

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).

=3+(120.74/489.35)

which is equal to

=3.25 years(Approx)

Since discounted payback is greater than 3 years the project must be rejected.

Hence the correct option is:

3.25 years;reject.