You recently went to work for Alliance Systems Company, a supplier of heavy duty machines used in the construction sites. Your boss, the chief financial officer (CFO), has just handed you the estimated cash flows for two proposed projects. Project L involves adding a new item to the firms ignition system line; it would take some time to build up the market for this product, so the cash inflows would increase over time. Project S involves an add-on to an existing line, and its cash flows would decrease over time. Both projects have 3-year lives, because Alliance is planning to introduce entirely new models after 3 years.

Here are the projects net cash flows (in thousands of dollars):

0 1 2 3

Project L -100 20 55 75

Project S -100 60 65 15

Depreciation, salvage values, net working capital requirements, and tax effects are all included in these cash flows.

The CFO also made subjective risk assessments of each project, and he concluded that both projects have risk characteristics that are similar to the firms average project. Alliances WACC is 10%.

(2) What is the rationale for the payback method? According to the payback criterion, which project(s) should be accepted if the firms maximum acceptable payback is 2 years, if Projects L and S are independent, if Projects L and S are mutually exclusive?

(3) What is the difference between the regular and discounted payback methods? What is Project L and Ss discounted payback, assuming a 10% cost of capital?

(4) What are the two main disadvantages of discounted payback? Is the payback method of any real usefulness in capital budgeting decisions? Explain.