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**

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