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

Use the PI decision rule to evaluate these projects; which one(s) should be accepted or rejected?

  Time: 0 1 2 3   Project A Cash Flow -30,000 20,000 40,000 11,000   Project B Cash Flow -40,000 20,000 30,000 60,000

Explanation / Answer

Present value of inflows=cash inflow*Present value of discounting factor(rate%,time period)

A:

Present value of inflows=20000/1.08+40000/1.08^2+11000/1.08^3

=$61544.23

PI=Present value of inflows/Present value of outflows

=61544.23/30000=2.05

B:

Present value of inflows=20000/1.08+30000/1.08^2+60000/1.08^3

=$91868.62

PI =$91868.62/$40000

=2.30

Hence since the projects are  mutually exclusive;B must be accepted only having higher PI.

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