Suppose your firm is considering two mutually exclusive, required projects with

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 12 percent and that the maximum allowable payback and discounted payback statistic for the projects are 2 and 3 years, respectively. Time Project A ash Flow Project B 0 24.000 4,000 34,000 5,000 34,000 14,000 24.000 54,000 Flow Use the discounted payback decision rule to evaluate these projects; which one(s) should be accepted or rejected? O accept neither A nor B O accept both A and B O reject A, accept B accept A, reject B

Explanation / Answer

Project A

CF0 = -24,000

CF1 = 14,000

CF2 = 34,000

CF3 = 5,000

Discount Rate = 12%

Discounted Cash Flow

CF0 = -24,000

CF1 = 14,000/ 1.12 = 12,500

CF2 = 34,000/ 1.122 = 27,104.59

CF3 = 5,000/ 1.123 = 3,558.90

Cash Flow left after 1 year = -24,000 + 12,500 = -11,500

Discounted Payback Period = 1 + 11,500/ 27,104.59

Discounted Payback Period = 1.42 years

Project B

CF0 = -34,000

CF1 = 14,000

CF2 = 24,000

CF3 = 54,000

Discount Rate = 12%

Discounted Cash Flow

CF0 = -34,000

CF1 = 14,000/ 1.12 = 12,500

CF2 = 24,000/ 1.122 = 19,132.65

CF3 = 54,000/ 1.123 = 38,436.13

Cash Flow left after 1 year = -34,000 + 12,500 = -21,500

Cash Flow left after 2 year = -21,500 + 19,132.65 = -2,367.35

Discounted Payback Period = 2 + 2,367.35/ 38,436.13

Discounted Payback Period = 2.06 years

As discounted for both projects is less than 3 years, we should select both thse projects

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