Question

The Square Box is considering two independent projects, both of which have an initial cost of $18,000. The cash inflows of Project A are $3,000, $7,000, and $10,000 over the next three years, respectively. The cash inflows for Project B are $3,000, $7,000, and $15,000 over the next three years, respectively. The required return is 12 percent and the required discounted payback period is 3 years. Based on discounted payback, which project(s), if either, should be accepted? Multiple Choice Both projects should be accepted. Both projects should be rejected. Project A should be accepted and Project B should be rejected. Project A should be rejected and Project B should be accepted. You should be indifferent to accepting either or both projects.

Answer 1

Answer:

Project A should be rejected and Project B should be accepted.

Explanation:

Discounted payback period calculates the amount of time it takes to recover the amount invested in a project from its discounted cash flows

Project A

Cash flow in year 0 = $-18,000

Cash flow in year 1 = $3,000

Cash flow in year 2 = $7,000

Cash flow in year 3 = $10,000

I = 12%

The present value of the cash flows are less than $18,000. This means that the cash flows would not be recovered within the 3 years so project A should not be accepted

Project B

Cash flow in year 0 = $-18,000

Cash flow in year 1 = $3,000

Cash flow in year 2 = $7,000

Cash flow in year 3 = $15,000

I = 12%

Discounted cash flow in year 1 = 3000 / 1.12 = 2678.57

Discounted cash flow in year 2 = 7000 / 1.12^2 = 5580.36

Discounted cash flow in year 3 = 15000 / 1.12^3 = 10676.70

The amount recovered in year 1  = $18,000 - 2678.57 = $15,321.43

The amount recovered in year 2  = $15,321.43 - 5580.36 = $9,741.07

The amount recovered in year 3  = $9,741.07 / 10676.70 = 0.912

The amount is recovered in 2.91 years which is less than 3 years and so it is accepted