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.

720

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

4.00 years, reject

1.11 years, accept

0 years, accept

2.69 years, reject

  Time 0 1 2 3 4 5 6   Cash Flow -1,100 80 520 720 720 320

720

Explanation / Answer

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+(500/720)

=2.69years

Hence since payback is greater than 2 years;project must be rejected.(D).

Year Cash flows Cumulative Cash flows 0 (1100) (1100) 1 80 (1020) 2 520 (500) 3 720 220 4 720 940 5 320 1260 6 720 1980

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