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).