Which of the following projects is acceptable given the required criteria for being so:
Considering three new projects, each requiring an initial equipment investment of $21,000. Each project will last for 3 years and produce the following cash flows:
Year Project 1 Project 2 Project 3
1 $ 7,000 $ 9,500 $13,000
2 9,000 9,500 10,000
3 15,000 9,500 11,000
Total $31,000 $28,500 $34,000
The equipment has no salvage value and SSA uses straight-line depreciation. No project will be accepted with a payback period over 2 years. Their minimum required rate of return is 12%.
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From the information provided about the projects it is seen that each of them has a initial cash outflow of $21000. The minimum required rate of return is 12% and no project with a payback period over 2 years would be accepted.
It is seen that the returns of project 1 over 2 years is 16000 and for project 2 it is 19000 even when the rate of return is taken to be 0. It is evident that these projects are not acceptable. For project 3, the returns over the first 2 years if they are not discounted is 23000 which is higher than the initial outflow. But on discounting each of them by 12% the inflow is 13000/1.12 + 10000/1.12^2 = 19579.08 which is lower than the initial outflow. The payback period is therefore greater than 2 years.
This shows that none of the three projects can be accepted as they do not provide a payback period of 2 years for a required rate of return of 12%.
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