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You are reviewing a new project
You are reviewing a new project. The required return for assets of this risk level is 12%. The estimated cash flows are: Year 0: CF = -165,000 Year 1: CF = 63,120; Net Income = 13,620 Year 2: CF = 70,800; Net Income = 3,300 Year 3: CF = 91,080; Net Income = 29,100 Average Book Value = 72,000 Assume we will accept the project if it pays back within two years and required AAR = 25% What is the payback period and the discounted payback period? What is the AAR? Should you accept or reject this project? o o
Expert Solution
Answer : Calculation of Payback Period :
Below is the table showing cash flows and cumulative cash flows:
| Year | Cashflows | Cumulative Cash Flows |
| 1 | 63120 | 63120 |
| 2 | 70800 | 133920 |
| 3 | 91080 | 225000 |
Payback Period = Complete years + (Initial Investment - Cash Flow recovered) / Cashflow for the year
= 2 + (165000 - 133920) / 91080
= 2.34 years
Discoounted Payback Perod :
| Year | Cash Inflows | PVF @ 12% | Present Value of Cash Inflow | Cumulative Discounted Cash flows |
| 1 | 63120 | 0.892857143 | 56357.14286 | 56357.14286 |
| 2 | 70800 | 0.797193878 | 56441.32653 | 112798.4694 |
| 3 | 91080 | 0.711780248 | 64828.94497 | 177627.4144 |
Discounted Payback Period = Complete years + (Initial Investment - Cash Flow recovered) / Cashflow for the year
= 2 + (165000 - 112798.4694) / 64828.94497
= 2.81 years
Calculation of AAR
AAR = Average Net Income / Average Book value
= [(13620 + 3300 + 29100) / 3] / 72000
= 15340 / 72000
= 21.31%
Since Payaback Period and AAR both are not within the acceptable limit therefore Reject the project.
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