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

760

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

a). 4.00 years, reject

b). 1.05 years, accept

c). 2.71 years, reject

d). 0 years, accept

  Time 0 1 2 3 4 5 6   Cash Flow -1,140 40 560 760 760 360

760

Explanation / Answer

The correct answer is c). 2.71 years, reject

Note :

Payback Period = ( Last Year with a Negative Cash Flow ) + [( Absolute Value of negative Cash Flow in that year)/ Total Cash Flow in the following year)]

= 2+ ( 540 / 760)

= 2.71 Years

Since , the  maximum allowable payback is 2 Years , and the actual payback period is 2.71 Years which is more than the maximum allowable payback , hence the project must be rejected.

Year Investment Cash Inflow Net Cash Flow 0 -1,140.00 -    -1,140.00 (Investment + Cash Inflow) 1 -    40 -1,100.00 (Net Cash Flow + Cash Inflow) 2 -    560 -540.00 (Net Cash Flow + Cash Inflow) 3 -    760 220.00 (Net Cash Flow + Cash Inflow) 4 -    760 980.00 (Net Cash Flow + Cash Inflow) 5 -    360 1,340.00 (Net Cash Flow + Cash Inflow) 6 -    760 2,100.00 (Net Cash Flow + Cash Inflow)

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