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 7 percent, and that the maximum allowable payback and discounted payback statistics for the project are 2.5 and 3.5 years, respectively.

Time:   0   1   2   3   4   5   6
Cash flow:   –$4,800   $1,140   $2,340   $1,540   $1,540   $1,340   $1,140

Use the payback decision rule to evaluate this project.

Answer 1

Payback is the time within which cost of project is recovered back.
Calculation of Payback Period:
Year	Cash Flow	Cumulative Cash Flow
0	$       -4,800	$   -4,800
1	1,140	-3,660
2	2,340	-1,320
3	1,540	220
4	1,540	1,760
5	1,340	3,100
6	1,140	4,240
Payback period	=	2+(1320/1540)
	=	2.9 Years
Calculation of discounted payback period:
Year	Cash Flow	Discount factor	Discounted Cash Flow	Cumulative Discounted Cash Flow
a	b	c=1.07^-a	d=b*c	e
0	$       -4,800	1.0000	-4,800	-4,800
1	1,140	0.9346	1,065	-3,735
2	2,340	0.8734	2,044	-1,691
3	1,540	0.8163	1,257	-434
4	1,540	0.7629	1,175	741
5	1,340	0.7130	955	1,697
6	1,140	0.6663	760	2,456
Discounted Payback		=	3+(434/1175)
		=	3.4 Years
On the basis of payback decision, project is not accepted as payback period of 2.9 years is beyond the deadline of 2.5 years.
On the basis of discounted payback decision, project is accepted as payback period of 3.4 years is within the deadline of 3.5 years.