Suppose your firm is considering investing in a project with the cash flows show

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 12 percent, and that the maximum allowable payback and discounted payback statistic for the project are 2 and 3 years, respectively.

770

Use the payback decision rule to evaluate this project; should it be accepted or rejected?

0 years, accept

1.04 years, accept

2.71 years, reject

4.00 years, reject

  Time 0 1 2 3 4 5 6   Cash Flow -1,150 30 570 770 770 370

770

Explanation / Answer

PAY BACK PERIOD

= 2 + (-550 / 770)

= 2 + 0.71

= 2.71 YEARS

AS MAXIMUM ALLOWABLE PAY BACK PERIOD IS 2 YEARS , THE PROJECT SHOULD BE REJECTED.

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DISCOUNTED PAYBACK PERIOD

DISCOUNTED PAY BACK PERIOD

= 3 + (-$120.72 / $489.34)

= 3 + 0.25

= 3.25 YEARS

AS MAXIMUM ALLOWABLE DISCOUNTED PAY BACK PERIOD IS 3 YEARS , THE PROJECT SHOULD BE REJECTED.

YEAR CASH FLOW CUMULATIVE CASH FLOW 0 -1150 -1150 1 30 -1120 2 570 -550 3 770 220 4 770 990 5 370 1360 6 770 2130

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