Question

1.      Suppose your firm is considering two mutually exclusive, required projects with the cash flows shown as follows. The required rate of return on projects of both of their risk class is 10 percent, and the maximum allowable payback and discounted payback statistic for the projects are two and a half and three and a half years, respectively.

Time	0	1	2	3
Project A Cash Flow	?1,000	300	400	700
Project B Cash Flow	?500	200	400	300

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

Answer 1

A:

Year	Cash flows	Present value@10%	Cumulative Cash flows
0	(1000)	(1000)	(1000)
1	300	272.73	(727.27)
2	400	330.58	(396.69)
3	700	525.92	129.23(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).

2+(396.69/525.92)

=2.75 years(Approx).

B:

Year	Cash flows	Present value@10%	Cumulative Cash flows
0	(500)	(500)	(500)
1	200	181.82	(318.18)
2	400	330.58	12.40
3	300	225.39	237.79(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+(318.18/330.58)

=1.96 years(Approx).

Hence since projects are mutually exclusive,B must be selected only having lower discounted payback period.