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  • Project A Project B: Payback Period

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    Tudor Andrei
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    The payback period is used to calculate the time required for the returns of a project to repay the initial investment. It involves assessing all costs, comparing them to expected revenues, and applying the firm's discount rate. For the example projects, Project A has a payback period of 2.86 years while Project B has a payback period of 4.03 years, so Project A would be selected as it recovers the investment faster.

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    The payback period is used to calculate the time required for the returns of a project to repay the initial investment. It involves assessing all costs, comparing them to expected revenues, and applying the firm's discount rate. For the example projects, Project A has a payback period of 2.86 years while Project B has a payback period of 4.03 years, so Project A would be selected as it recovers the investment faster.

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    © All Rights Reserved
    Download as XLSX, PDF, TXT or read online from Scribd
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    Download as xlsx, pdf, or txt
    16 views8 pages

    Project A Project B: Payback Period

    Uploaded by

    Tudor Andrei
    The payback period is used to calculate the time required for the returns of a project to repay the initial investment. It involves assessing all costs, comparing them to expected revenues, and applying the firm's discount rate. For the example projects, Project A has a payback period of 2.86 years while Project B has a payback period of 4.03 years, so Project A would be selected as it recovers the investment faster.

    Copyright:

    © All Rights Reserved
    Download as XLSX, PDF, TXT or read online from Scribd
    Flag for inappropriate content
    Download as xlsx, pdf, or txt
    of 8

    Payback Period

    (the estimated amount of time that will be necessary to recoup the investment in a project)

    1. all potential costs of development are assesed BEFORE the decision to implement the project
    2. costs are compared with all the expected sources of revenue from the project
    3. a discount rate based on the firm's cost of capital is applied to this calculation

    Example:

    Our company wants to determine which of 2 project alternatives is the more attractive investment opportunity
    by using a payback period approach. We have calculated the initial investment cost of the 2 projects and the expected
    revenues they should generate for us. Which project should we invest in?

    Initial data:

    Project A Project B
    Revenues Outlays Revenues Outlays
    Year 0 0.00 € 500,000.00 € 0.00 € 500,000.00 €
    Year 1 50,000.00 € 75,000.00 €
    Year 2 150,000.00 € 100,000.00 €
    Year 3 350,000.00 € 150,000.00 €
    Year 4 600,000.00 € 150,000.00 €
    Year 5 500,000.00 € 900,000.00 €

    Solution:

    Project A Project B
    Cumulative
    Year Cash Flow Cash Flow Year Cash Flow
    0 -500,000.00 € -500,000.00 € 0 -500,000.00 €
    1 50,000.00 € -450,000.00 € 1 75,000.00 €
    2 150,000.00 € -300,000.00 € 2 100,000.00 €
    3 350,000.00 € 50,000.00 € 3 150,000.00 €
    4 600,000.00 € 650,000.00 € 4 150,000.00 €
    5 500,000.00 € 1,150,000.00 € 5 900,000.00 €

    PP 2.86 PP 4.03
    Note:
    To determine the payback period with the fraction of the year, I used:
    No. of years before first positive cumulative cash flow + (Absolute value of last negative cumulative cash flow / Cash flow i
    ent in a project)

    nt the project

    active investment opportunity


    st of the 2 projects and the expected

    oject B
    Cumulative Cash
    Flow
    -500,000.00 €
    -425,000.00 €
    -325,000.00 €
    -175,000.00 €
    -25,000.00 €
    875,000.00 €

    ative cumulative cash flow / Cash flow in the year of first positive cumulative cash flow)
    Net Present Value

    A positive NPV indicates that the firm will make money as a result of the project.
    A negative NPV shows a loss.

    Example:

    Should you invest $60,000 in a project that will return $15,000 per year for five years?
    You have a minimum return of 11%.

    Inflows/Ouflaws
    Year 0 -60,000.00 €
    Year 1 15,000.00 €
    Year 2 15,000.00 €
    Year 3 15,000.00 €
    Year 4 15,000.00 €
    Year 5 15,000.00 €
    NPV -4109.50
    The NPV is
    negative, so don’t
    invest!
    Internal Rate of Return

    Higher the IRR, better the project.

    Example:

    Our company wants to determine which of 2 project alternatives is the more attractive investment opportunity.
    We have calculated the initial investment cost of the 2 projects and the expected
    revenues they should generate for us. Which project should we invest in?

    Revenues/outlays
    Project A Project B
    Year 0 -500,000.00 € -500,000.00 €
    Year 1 50,000.00 € 75,000.00 €
    Year 2 150,000.00 € 100,000.00 €
    Year 3 350,000.00 € 150,000.00 €
    Year 4 600,000.00 € 150,000.00 €
    Year 5 500,000.00 € 900,000.00 €
    IRR 39% 29%
    Example:

    A project that costs $40,000 will generate cash flows of $14,000 for the next four years.
    You have a rate of return requirement of 17%; does this project meet the threshold?

    Year 0 -40,000.00 €
    Year 1 14,000.00 €
    Year 2 14,000.00 €
    Year 3 14,000.00 €
    Year 4 14,000.00 €
    IRR 15%
    ment opportunity.

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