Years

0 1 2 3 4 5
($290,000) $106,100 $118,000 $95,830 $132,850 $120,000

($290,000) ($183,900) ($65,900) $29,930 $162,780 $282,780

Shortest possible according to me >>> 2.687676

OR

In case of loss making projects >>>>> 2.687676

Option 1 0 1 2 3 4
Purchase Band Saw
Band Saw Cost 50000 per investment -50000 10000 10000 10000 10000
target Cashflow 10000 per year
payback period 5 years -40000 -30000 -20000 -10000

Option 2 0 1 2 3
Purchase of Conveyor system
Conveyor costs 36000 investment -36000 12000 12000 12000
Cost optimization 12000 per year
payback period 3 years -24000 -12000 0
5

10000

0
LASANI Stone Crushing company is considering to purchase a new machine. The cost of the machine is $
The machine will reduce annual costs by $75,000.

The management uses payback period method to evaluate capital investments because the quick recove

Required:

Compute the payback period for this proposal. Would the company purchase new machine if maximum de

Solution:
Computation of payback period:

The cost saving of the machine is even (i.e., same amount of cost savings each year). The payback period

required to purchase the machine/Net annual cost savings

= $360,000/$75,000

= 4.8 years

Conclusion:

The payback period of the machine is 4.8 years which is longer than the desired payback period of the com
ost of the machine is $360,000 and the life of the machine is 10 years.

ause the quick recovery of any capital investment is very important for the company.

achine if maximum desired payback period of the management is 4 years?

r). The payback period can therefore be easily computed using payback period formula:

back period of the company. The machine would therefore not be purchased.
The investment and expected cash inflows of a project over 8-year period is given below:

Required: Compute the payback period of the project. Would the project be acceptable if the maximum

1 2 3 4 5 6
Unrecovered (6,000.00) (6,000.00) (2,000.00) (4,000.00) (3,000.00)
Investment at the start
of the year

Investments (8,000.00) (4,000.00)

Cash Inflows 2,000.00 - 4,000.00 2,000.00 1,000.00 6,000.00
Unrecovered (6,000.00) (6,000.00) (2,000.00) (4,000.00) (3,000.00) -
Investments at the end
of the year

Payback period Years before full recovery + (Unrecovered investment at start of the year/Cash flow during the yea

As the expected cash flows is uneven (different cash flows in different periods), the payback formula ca
The payback period for this project would be computed by tracking the unrecovered investment year by

Payback period = years before full recovery + (Unrecovered investment at start of the year/Cash
= 5 + (3,000/6,000)

5.5

= 5.5 years or 5 years and *6 months

*0.5 × 12

The entire investment is expected to recover by the middle of sixth year. The payback period of this pro

Conclusion:

The project is acceptable because payback period promised by the project is shorter than the maximum
s given below:

e acceptable if the maximum desired payback period is 7 years?

7 8
- -

4,000.00 4,000.00
- -

the year/Cash flow during the year)

ds), the payback formula cannot be used to compute payback period of this project.
ecovered investment year by year.

nt at start of the year/Cash flow during the year)

e payback period of this project is, therefore, 5.5 years or 5 years and six moths.

is shorter than the maximum desired payback period of the management.

Exercise-10 (Payback period method with salv
he Black Stone company sells crushed stone to government contractors as well as to small business owne
The company needs to replace an old equipment with a new one.
The new equipment can increase production as well as improve the quality of crushed stone.
The information about annual incremental revenues and costs associated with the new equipment is given

The only non-cash expense in the above income statement is the depreciation. The new equipment would cost $240,000 and

Required: Would the company invest in new equipment if the desired payback period is 2.5 years or less?

Solution:
Step 1 Computation of net annual cash inflow:

The net operating income is not equal to net cash flow because it has been obtained after taking into acco

$60,000 + $30,000 = $90,000

Step 2: Computation of investment:

The price of new equipment is $240,000 and the salvage value of the old equipment is $15,000. The requi

Step 3: Computation of payback period:

tment required for the project/Net annual cash inflow

= $225,000/$90,000

= 2.5 years
The equipment promises a payback period of 2.5 years that is equal to the maximum desired payback peri
od with salvage value)
as to small business owners involved in construction business.

shed stone.
e new equipment is given below:

ent would cost $240,000 and the old equipment can be sold to a small company for its salvage value of $15,000.

eriod is 2.5 years or less?

ned after taking into account the depreciation – a non-cash expense. We would add the depreciation back to net ope

ent is $15,000. The required investment is, therefore, $225,000 ($240,000 – $15,000).
mum desired payback period of the company. The equipment would, therefore, be purchased.
preciation back to net operating income to get the incremental net cash inflow figure. It is shown below:
own below:
1. Payback Period – Given the cash flows of the four projects, A, B, C, and D, and using the Payback Period decisio
which projects do you accept and which projects do you reject with a three year cut-off period for recapturing the initial cash
Assume that the cash flows are equally distributed over the year for Payback Period calculations.

Project A

Project 0 1 2 3 4 5 6
A -10000 4000 4000 4000 4000 4000 4000
-6000 -2000 2000 6000 10000 14000

B -25000 2000 8000 14000 20000 26000 32000

-23000 -15000 -1000 19000 45000 77000

C -45000 10000 15000 20000 20000 15000 10000

-35000 -20000 0 20000 35000 45000

D -100000 40000 30000 20000 10000 0 0

-60000 -30000 -10000 0 0 0
the Payback Period decision model,
or recapturing the initial cash outflow?
1. Discounted Payback Period – Given the following four projects and their cash flows, calculate the discounted
What do you notice about the payback period as the discount rate rises? Explain this relationship.

Solution at 5% discount rate

Project A 0 1 2 3 4 5 6
Discount Rate 1.05 1.1025 1.157625 1.215506 1.276282 1.340096
Cashflow 4000 4000 4000 4000 4000 4000
Discounted Cashflows -10000 3809.524 3628.118 3455.35 3290.81 3134.105 2984.862

Cumulative Cashflow -6190.476 -2562.358 892.9921 4183.802 7317.907 10302.77

Payback Period 2.70625

Project B 0 1 2 3 4 5 6
Discount Rate 1.05 1.1025 1.157625 1.215506 1.276282 1.340096
Cashflow 2000 8000 14000 20000 26000 32000
Discounted Cashflows -25000 1904.762 7256.236 12093.73 16454.05 20371.68 23878.89

Cumulative Cashflows -23095.24 -15839 -3745.276 12708.77 33080.45 56959.35

Payback Period 3.309688

1. Comparing Payback Period and Discounted Payback Period – Neilsen Incorporated is switching from Paybac
The cut-off period will remain at 3 years. Given the following four projects cash flows and using a 10% discount

Solution
Calculate the Discounted Payback Periods of each project at 10% discount rate:

Project 1 1 2 3 4 5 6 7
Discount Rate 1.1 1.21 1.331 1.4641 1.61051 1.771561 1.948717
Cashflow 4000 4000 4000 4000 4000 4000 4000
Discunted -10000 3636.364 3305.785 3005.259 2732.054 2483.685 2257.896 2052.632

Cumulative Cashflow -6363.636 -3057.851 -52.59204 2679.462 5163.147 7421.043 9473.675

Payback Period 3.0175 No Go

Project 3 1 2 3 4
Discount Rate 1.1 1.21 1.331 1.4641
Cashflow 3000 3500 4000 4000
Discounte -8000 2727.273 2892.562 3005.259 2732.054

Cumulative Cashflow -5272.727 -2380.165 625.0939 3357.148

Payback Period 2.822857 Go

flows, calculate the discounted payback period with a 5% discount rate, 10% discount rate, and 20% discount rate.
s relationship.

Project C 0 1 2 3 4 5
Discount Rate 1.05 1.1025 1.157625 1.215506 1.276282
Cashflow 10000 15000 20000 20000 15000
Discounted Cashflow -45000 9523.81 13605.44 17276.75 16454.05 11752.89

Cumulative Cashflows -35476.19 -21870.75 -4594 11860.05 23612.95

Payback Period 3.265906

Project D 0 1 2 3 4 5
Discount Rate 1.05 1.1025 1.157625 1.215506 1.276282
Cashflows 40000 35000 20000 10000 10000
Discounted Cashflows -100000 38095.24 31746.03 17276.75 8227.025 7835.262

Cumulative Cashflow -61904.76 -30158.73 -12882 -4654.953 3180.308

Payback Period 4.565813

rated is switching from Payback Period to Discounted Payback Period for small dollar projects.
ows and using a 10% discount rate, which projects that would have been accepted under Payback Period will now be rejected
8 9 Project 2 1 2 3
2.143589 2.357948 Discount Rate 1.1 1.21 1.331
4000 4000 Cashflow 7000 5500 4000
1866.03 1696.39 Discounted -15000 6363.636 4545.455 3005.259

11339.7 13036.1 Cumulative Cashflow -8636.364 -4090.909 -1085.65

Payback Period 3.36125 No Go

Project 4 1 2 3
Discount Rate 1.1 1.21 1.331
Cashflow 10000 11000 0
Discounted -18000 9090.909 9090.909 0

Cumulative Cashflow -8909.091 181.8182 181.8182

Payback Period 1.98 Go

d 20% discount rate.

6
1.34009564
10000
7462.15397

31075.0996

6
1.34009564
0
0

3180.30822

ack Period will now be rejected under Discounted Payback Period?

4
1.4641
4000
2732.05382

2913.872
1. Net Present Value – Swanson Industries has a project with the following projected cash flows:
Initial Cost, Year 0: $240,000
Cash flow year one: $25,000
Cash flow year two: $75,000
Cash flow year three: $150,000
Cash flow year four: $150,000
a. Using a 10% discount rate for this project and the NPV model should this project be accepted or r
b. Using a 15% discount rate?
c. Using a 20% discount rate?

0 1 2 3 4
Discount rate 1 1 1 1
Cashflows 25,000 75,000 150,000 150,000
Discounted Cashflows (240,000) 22,727 61,983 112,697 102,452

Cum. Discounted (217,273) (155,289) (42,592) 59,860

Cashflows

NPV 59,860
s project be accepted or rejected?
Imagine a company can invest in equipment that will cost $1,000,000 and is expected to generate

Step One: NPV of the Initial Investment

Because the equipment is paid for up front, this is the first cash flow included in the calculation. Th

Identify the number of periods (t)

The equipment is expected to generate monthly cash flow and last for five years, which means the

Identify the discount rate (i)

The alternative investment is expected to pay 8% per year. However, because the equipment gene

\text{Periodic Rate} = (( 1 + 0.08)^{\frac{1}{12}}) - 1 = 0.64\%Periodic Rate=((1+0.08)121)−1=0.64% ​

Step Two: NPV of Future Cash Flows

Assume the monthly cash flows are earned at the end of the month, with the first payment arriving

The full calculation of the present value is equal to the present value of all 60 future cash flows, mi

NPV = -\$1,000,000 + \sum_{t = 1}^{60} \frac{25,000_{60}}{(1 + 0.0064)^{60}}NPV=−$1,000,000+∑

That formula can be simplified to the following calculation:

NPV = -\$1,000,000 + \$1,242,322.82 = \$242,322.82NPV=−$1,000,000+$1,242,322.82=$242,322.82

In this case, the NPV is positive; the equipment should be purchased. If the present value of these

Net Present Value Drawbacks and Alternatives

Gauging an investment’s profitability with NPV relies heavily on assumptions and estimates, so the

Payback period, or “payback method,” is a simpler alternative to NPV. The payback method calculates how long it will take for

Moreover, the payback period is strictly limited to the amount of time required to earn back initial in

Net Present Value vs. Internal Rate of Return

Internal rate of return (IRR) is very similar to NPV except that the discount rate is the rate that reduces the NPV of an investme

For example, IRR could be used to compare the anticipated profitability of a three-year project that

The Bottom Line

Net present value (NPV) is the calculation used to find today’s value of a future stream of payment
s expected to generate $25,000 a month in revenue for five years. The company has the capital available fo

ed in the calculation. There is no elapsed time that needs to be accounted for so today’s outflow of $1,000,0

years, which means there will be 60 cash flows and 60 periods included in the calculation.

use the equipment generates a monthly stream of cash flows, the annual discount rate needs to be turned in

((1+0.08)121)−1=0.64%
​

e first payment arriving exactly one month after the equipment has been purchased. This is a future paymen

60 future cash flows, minus the $1,000,000 investment. The calculation could be more complicated if the equ

0}}NPV=−$1,000,000+∑t=160(1+0.0064)6025,00060
​ ​

2,322.82=$242,322.82

e present value of these cash flows had been negative because the discount rate was larger, or the net cash

ns and estimates, so there can be substantial room for error. Estimated factors include investment costs, dis

ulates how long it will take for the original investment to be repaid. A drawback is that this method fails to account for the time value of m

ed to earn back initial investment costs. It is possible that the investment’s rate of return could experience sh

educes the NPV of an investment to zero. This method is used to compare projects with different lifespans or amount of required capital.

a three-year project that requires a $50,000 investment with that of a 10-year project that requires a $200,00

ture stream of payments. It accounts for the time value of money and can be used to compare investment a
s the capital available for the equipment and could alternatively invest it in the stock market for an expected r

ay’s outflow of $1,000,000 doesn’t need to be discounted.

te needs to be turned into a periodic or monthly rate. Using the following formula, we find that the periodic ra

This is a future payment, so it needs to be adjusted for the time value of money. An investor can perform th

e complicated if the equipment was expected to have any value left at the end of its life, but, in this example

s larger, or the net cash flows were smaller, the investment should have been avoided.

de investment costs, discount rate, and projected returns. A project may often require unforeseen expenditur

ccount for the time value of money. For this reason, payback periods calculated for longer investments have a greater potential for inaccu

urn could experience sharp movements. Comparisons using payback periods do not account for the long-te

r amount of required capital.

that requires a $200,000 investment. Although the IRR is useful, it is usually considered inferior to NPV bec

o compare investment alternatives that are similar. The NPV relies on a discount rate of return that may be d
market for an expected return of 8% per year. The managers feel that buying the equipment or investing in th

e find that the periodic rate is 0.64%.

investor can perform this calculation easily with a spreadsheet or calculator. To illustrate the concept, the fir

life, but, in this example, it is assumed to be worthless.

e unforeseen expenditures to get off the ground or may require additional expenditures at the project’s end.

e a greater potential for inaccuracy.

t account for the long-term profitability of alternative investments.

ered inferior to NPV because it makes too many assumptions about reinvestment risk and capital allocation.

of return that may be derived from the cost of the capital required to make the investment, and any project
ipment or investing in the stock market are similar risks.

rate the concept, the first five payments are displayed in the table below.

es at the project’s end.

k and capital allocation.

tment, and any project or investment with a negative NPV should be avoided. An important drawback of usi
portant drawback of using an NPV analysis is that it makes assumptions about future events that may not be
e events that may not be reliable.