Question

Suppose your firm is considering two mutually exclusive, required projects with the cash flows shown below. 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 2.5 and 3.5 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 payback decision rule to evaluate these projects; which one(s) should be accepted or rejected?

		accept both A and B
		accept neither A nor B
		accept A, reject B
		reject A, accept B

Answer 1

A:

Year	Cash flows	Cumulative Cash flows
0	(1000)	(1000)
1	300	(700)
2	400	(300)
3	700	400

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+(300/700)

=2.43 years(Approx)

B:

Year	Cash flows	Cumulative Cash flows
0	(500)	(500)
1	200	(300)
2	400	100
3	300	400

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+(300/400)

=1.75 years

Hence since projects are mutually exclusive;project B must be selected only having lower payback .

Hence the correct option is:

reject A, accept B