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 9 percent, and that the maximum allowable payback and discounted payback statistics for the project are 2.5 and 3.5 years, respectively.

Time:	0	1	2	3	4	5	6
Cash flow:	–$4,900	$1,190	$2,390	$1,590	$1,590	$1,390	$1,190

Use the payback decision rule to evaluate this project. (Round your answer to 2 decimal places.)

Answer 1

To calculate the payback period, we need to find the time that the project has recovered its initial investment. After two years, the project has created:

$1,190 + $2,390 = $3,580

in cash flows. The project still needs to create another:

$4,900 - $3,580 = $1,320

in cash flows. During the third year, the cash flows from the project will be $1,590. So, the payback period will be two years, plus what we still need to make divided by what we will make during the third year. The payback period is:

Payback = 2 + ($1,320 / $1,590) = 2.83 years

The project should be accepted.