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 11 percent, and that the maximum allowable payback and discounted payback statistic for the projects are 2 and 3 years, respectively. Time: 0 1 2 3 Project A Cash Flow -33,000 23,000 43,000 14,000 Project B Cash Flow -43,000 23,000 7,000 63,000 Use the payback decision rule to evaluate these projects; which one(s) should be accepted or rejected? accept A, reject B accept both A and B accept neither A nor B reject A, accept B

Explanation / Answer

Project A:

Payback period = 1 + [33000 -23000]/43000

                        = 1 + [10000/43000]

                       = 1 + .23

                         = 1.23 years

[Payback period = period up to which cummulative cash flow iss negative + negative cummulative cash flow /cash flow of next period]

cummulative cash flow up to year 1 = -33000 +23000 = -10000

year 2 = -10000 + 43000= 33000

Project B= 2 + [13000 / 63000]

             = 2 + .21

             = 2.21 years

[Cummulative cash flow year1 =-43000 +23000 = -20000

year 2 = -20000 + 7000 = -13000

year3 = -13000 + 63000 = ]

correct option is "A"accept A as its payback period is less than B as well as acceptable criteria ( 2)

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