Payback Period

 Number of years needed to recover the initial

cash outlay of a capital-budgeting project
 Decision Rule: Project feasible or desirable if
the payback period is less than or equal to the
firm’s maximum desired payback period.

Keown, Martin, Petty - Chapter 9 1

 Payback Period Example
Example: Project with an initial cash outlay of $16,000
with following free cash flows for 5 years.
YEAR CASH FLOW ACCUM.CASH
FLOWS
1 $ 8,000 $8,000
2 4,000 12,000
3 3,000 15,000
4 5,000 20,000
5 10,000
Payback = 3years + (16,000-15,000) / 5,000
= 3.2 years
Keown, Martin, Petty - Chapter 9 2
NPV Example

Example: Project with an initial cash outlay of $60,000

with following free cash flows for 5 years.

Yr FCF Yr FCF
Initial outlay -60,000 3 13,000
1 25,000 4 12,000
2 24,000 5 11,000

The firm has a 15% required rate of return.

Keown, Martin, Petty - Chapter 9 3

NPV in Excel
 Input cash flows for initial outlay and
inflows in cells A1 to A6

 In cell A7 type the following formula:

 =A1+npv(.15,a2:a6)

 Excel will give the NPV = $764

Keown, Martin, Petty - Chapter 9 4

 Internal Rate of Return or IRR

 IRR is the discount rate that equates the

present value of a project’s future net
cash flows with the project’s initial cash
outlay
 Decision Rule:
 If IRR > Required rate of return, accept
 IF IRR < Required rate of return, reject

Keown, Martin, Petty - Chapter 9 5

IRR and NPV
 If NPV is positive, IRR will be greater
than the required rate of return
 If NPV is negative, IRR will be less than
required rate of return
 If NPV = 0, IRR is the required rate of
return.

Keown, Martin, Petty - Chapter 9 6

IRR Example

Initial Outlay: $3,817

Cash flows:
Yr.1=$1,000, Yr. 2=$2,000, Yr. 3=$3,000
Discount rate NPV
15% $4,356
20% $3,958
22% $3,817
IRR is 22% because the NPV equals the initial
cash outlay
Keown, Martin, Petty - Chapter 9 7
IRR in Excel
 Input cash flows for initial outlay and
inflows in cells A1 to A4

 In cell A5 type the following formula:

 =IRR(A1:A4)

 Excel will give the IRR = 22%

Keown, Martin, Petty - Chapter 9 8