Question

1. Suppose your firm is considering two independent projects with the cash flows shown as follows. The required rate of return on projects of both of their risk class is 12 percent, and the maximum allowable payback and discounted payback statistic for the projects are two and a half and three years, respectively.

Time |
0 |
1 |
2 |
3 |

Project A Cash Flow |
?5,000 |
1,000 |
3,000 |
5,000 |

Project B Cash Flow |
?10,000 |
5,000 |
5,000 |
5,000 |

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

A. ACCEPT BOTH A AND B

B. ACCEPT NEITHER A NOR B

C. ACCEPT A, REJECT B

D. REJECT A, ACCEPT B

Answer #1

A:

Year | Cash flows | Cumulative Cash flows |

0 | (5000) | (5000) |

1 | 1000 | (4000) |

2 | 3000 | (1000) |

3 | 5000 | 4000 |

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+(1000/5000)

=2.2 years

B:

Year | Cash flows | Cumulative Cash flows |

0 | (10000) | (10000) |

1 | 5000 | (5000) |

2 | 5000 | 0 |

3 | 5000 | 5000 |

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 years.

Hence since projects are independent;both the projects must be
accepted having payback lower than 2.5
years.**(A).**

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Time
0
1
2
3
Project A Cash Flow
?20,000
10,000
30,000
1,000
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?30,000
10,000
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