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 8 percent, and that the maximum allowable payback and discounted payback statistic for the project are 3 and 3.5 years, respectively. Use the payback decision rule to evaluate this project; should it be accepted or reject

Time              0           1        2        3        4       5

Cash Flow    -1000     500    480    400    300   150

Select one:

a. 2.45 years, accept

b. 2.83 years, accept

c. 3.45 years, accept

d. 3.83 years, reject

Note: Can you please show me how you calculated it all? I followed along to a YouTube video, but my answer wasn't in the options, so I know I did it wrong. I tried to do it in Excel. Thank you!

Explanation / Answer

Payback period = Cashflow of Year 1 + Cashflow of Year 2 + (1000 - 500 - 480) / Cashflow of Year 3

= 2 + (1000 - 500 - 480) / 400

= 2.05 years which is less than 3 years and hence acceptable.

Discounnted Payback period = Discounted Cashflow of Year 1 + Discounted Cashflow of Year 2 + [1000 - 500/(1+8%) - 480/(1+8%)2] / Discounted Cashflow of Year 3

= 2 + 125.52 / [400/(1+8%)3]

= 2.40 years which is less than 3.5 years and hence again acceptable.

So, closest option is (a) 2.45 years, accept

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