Example 2: Payback Period

 Johnson Controls (JCI) announced a plan to set up a facility

to manufacture batteries for hybrid vehicles in Milwaukee,
Wisconsin. The company estimates that the facility would
cost $16.2 million now and generate the following cash flows
over the first 4 years of its life:

 CF1 = $2.8 million CF3 = $4.9 million

 CF2 = $3.6 million CF4 = $5.5 million
 Maximum allowed payback period: 4 years

 Required return for assets of this risk: 10%

 What is the project’s payback period? What is the NPV of the

project’s cash flows over the first 4 years?
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 Example 2: Solution
(Payback Period)
Compute the remaining balance in the initial investment for
each year until recovery:
Year 1: 16,200,000 – 2,800,000 = $13,400,000
Year 2: 13,400,000 – 3,600,000 = $9,800,000
Year 3: 9,800,000 – 4,900,000 = $4,900,000
Year 4: 4,900,000 – 5,500,000 = -$600,000
Project pays back in year 4  Accept

Fraction of year 4 until recouping investment :

(balance at the beginning of year 4)/(cash flow for year 4)
= 4,900,000 / 5,500,000 = 0.89 of a year (i.e. 0.89 x 12 = 10.68 months)
The project recoups itself in 3.89 years (i.e. in November of year 4) 2
 Example 2: Solution (NPV)
 Formula:
 NPV = -$16,200,000 + $2,800,000/(1.1) + $3,600,000/(1.1)2 +
$4,900,000/(1.1)3 + $5,500,000/(1.1)4
= -$3,241,322.31
 Calculator:
 [CF] [2nd] [CLR WORK]
 [-16200000] [ENTER][↓]
 [2800000] [ENTER][↓] [ENTER][↓]
 [3600000] [ENTER][↓] [ENTER][↓]
 [4900000] [ENTER][↓] [ENTER][↓]
 [5500000] [ENTER][↓] [ENTER][↓]
 [2nd] [QUIT] ↓
 [NPV] [10] [ENTER][↓]
 [CPT] ↓
  Reject
 Why did the payback period and NPV yield different recommendations?
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 Example 3: IRR
 You are evaluating an investment project, whose expected cash
flows are summarized below.

 What is the IRR of this project?

 If the required rate of return is 10%, would you go ahead with the
project?
Year Cash Flow
1 -$24,000
2 $8,000
3 $12,000
4 $9,000
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 Example 3: Solution
 There is no direct formula for the IRR. To find the IRR, use either your
calculator or Excel (function IRR)

 Calculator:
 [CF] [2nd] [CLR WORK] [ENTER][↓]
 [-24000] [ENTER][↓] [ENTER][↓]
 [8000] [ENTER][↓] [ENTER][↓]
 [12000] [ENTER][↓] [ENTER][↓]
 [9000] [ENTER][↓] [ENTER][↓]
 [2nd] [QUIT] ↓
 [IRR] ↓
 [CPT] ↓ IRR = 9.89%

 Decision: since IRR < 10%  Reject

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 Example 4: Multiple IRRs
 You have discovered a small coal site. Developing this site
requires an immediate investment of $90,000. You can extract
most of the coal over the first three years, after which mining
becomes economically unviable. However, before you abandon
the site at the end of year 3, the Environmental Protection Agency
requires an investment in restoring the ecosystem of the location.
Project cash flows are as follows:

Year 0: -$90,000 Year 2: $100,000

Year 1: $132,000 Year 3: -$150,000

If the required return is 15%, what are the NPV and the IRR of the
project?

Should we go ahead with the investment?

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 Example 4: Solution
Calculator:
 [CF] [2nd] [CLR WORK]
 [-90000] [ENTER][↓]
 [132000] [ENTER][↓] [ENTER][↓]
 [100000] [ENTER][↓] [ENTER][↓]
 [-150000] [ENTER][↓] [ENTER][↓]
 [2nd] [QUIT] ↓
 [NPV] [15] [ENTER][↓]
 [CPT] ↓ ↓

  NPV = $1,769.54
  IRR = 10.11% & 42.66%

 You calculator will show only the first IRR

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 To calculate the second IRR, use the function IRR in Excel
 Example 4: Project’s NPV and
Multiple IRRs
$4,000.00
IRR1 = 10.11%
$2,000.00

$0.00
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55
($2,000.00)
NP V

($4,000.00)

($6,000.00) NPV = $1,770 > 0

IRR2 = 42.66%
($8,000.00)

($10,000.00)
Discount Rate
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 Example 4: Summary
 NPV Decision:
NPV = $1,769.54 > 0  Accept

 IRR Decision:
Unclear due to multiple IRRs: 10.11% < r < 42.66%

If there are multiple IRRs, use the NPV criterion