Initial Project

Screening Method Payback Period

Lecture No.15
Chapter 5

Describing Project Cash Flows

example 1
Year
(n)

Cash Inflows
(Benefits)

Cash Outflows
(Costs)

Net Cash Flows

Cash inflows cash outflows
Benefits Cost)

$650,000

-$650,000

215,500

53,000

162,500

215,500

53,000

162,500

215,500

53,000

162,500

Cash Flow Diagram for Project

cashflows
Money-in (positive)

Money-out (negative)

Payback Period method

Principle:
How fast can I recover my initial investment?
Method:
Based on the cumulative cash flow (or accounting profit)
Screening Guideline:
If the payback period is less than or equal to some
specified payback period, the project would be considered
for further analysis.
Weakness:
Does not consider the time value of money
Does not consider cashflows after paybackperiod

Practice Problem

How long does it take to recover the initial investment

in example 1?

Initial Cost
Payback Period =
Uniform annual benefit
$650,000

$162,500
4 years

Example 2 Replacement
decision
Salvage value of
old machine

Cost of new
machine

Payback
period
(PP)

Cash Flow

0 -$105,000 + $20,000
$15,000
1
$25,000
2
$35,000
3
?

4
5
6

$45,000
$45,000
$35,000

Cum. Flow
-$85,000
-$70,000
-$45,000
-$10,000

Cum.
Cashflows:
one +ve and
one -ve

$35,000
$80,000
$115,000

Payback period should occurs somewhere between N = 3 and N =

4.

Annual cash flow

$25,000

$15,000

$45,000

$45,000

$35,000

0
1

2
Years

$85,000

Cumulative cash flow ($000)

$35,000

150

3.3 years
Payback period

100

Between year 3
and 4, so start
with year 3

50
0
-50

Cumulative
cashflows for
year 4

PP = 3 + (10000/35,000) = 3.3 yrs

-100
0

Years (n)

Cumulative
cashflows for year
3 (ignore ve sign)

Discounted Payback
Period
Principle:
How fast can I recover my initial investment
plus interest?
Method:
Based on the cumulative discounted cash flow
Screening Guideline:
If the discounted payback period (DPP) is less
than or equal to some specified payback period,
the project would be considered for further
analysis.
Weakness:
Cash flows occurring after DPP are ignored

Discounted Payback Period Calculation

example 3
Period

Cash Flow

-$85,000

Cost of Funds
(15%)*

Cumulative
Cash Flow

-$85,000

15,000

-$85,000(0.15) = -$12,750

-82,750

25,000

-$82,750(0.15) = -12,413

-70,163

35,000

-$70,163(0.15) = -10,524

-45,687

45,000

-$45,687(0.15) =-6,853

-7,540

45,000

-$7,540(0.15) = -1,131

36,329

35,000

$36,329(0.15) = 5,449

76,778

Cost of funds = (Unrecovered beginning balance) X (interest r

PP is between year 4
and year 5

Between year 4
and 5, so start
with year 3

Cumulative
cashflows for
year 5

PP = 4 + (7540/36,329) = 4.2 yrs

Cumulative
cashflows for year
4 (ignore ve sign)