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 8 percent, and that the maximum allowable payback and discounted payback statistics for the project are 3.5 and 4.5 years, respectively.

Time:	0	1	2	3	4	5	6
Cash flow:	-$5000	$1230	$2430	$1630	$1550	$1430	$1230

Use the payback decision rule to evaluate this project. Should this project be accepted or rejected? (Round your answers 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:

$1,230 + $2,430 = $3,660

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

$5,000 - $3,660 = $1,340

in cash flows. During the third year, the cash flows from the project will be $1,630. 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 + ($1,340 / $1,630) = 2.82 years

Accepted