Module 5: Evaluating a Single Project

Carbon Fibers in Automobiles

There is a rule-of-thumb that “if the weight of an automobile can be reduced by

10%, then 6% of the annual cost of gasoline can be saved.” Light weight and high
strength carbon fibers costing about $15–$20 per pound are currently being
considered to replace the metal in automobile and aerospace applications.
Engineers believe they can economically reduce the weight of an automobile by
substituting carbon fibers for metal to save 20% to 30% on fuel consumption each
year. Other structures such as stronger wind turbines can also be built with light
weight carbon fibers. After working through this chapter, you will be able to
evaluate the economic trade-off between annual fuel savings and up-front cost of
carbon fibers and to determine whether it is a smart trade-off.
 Chapter Objectives

At the end of this chapter, you will be able to:

• discuss and critique contemporary methods for
determining project profitability
• evaluate the economic profitability of a single
proposed problem solution

3
 Case Study – WalMart Stock

 In October 1,1970, when Wal-

Mart Stores, Inc. went public, an
investment of 100 shares cost
$1,650.
 That investment would have been
worth $15,384,576 on
September 30, 2014, after nine
times stock splits for 2 for 1.
What would be the rate of
return on this investment?
 The unit price of Walmart shares
now closed at more than $100 as
compared to $80 in 2014. What
is the estimated present worth of
the original 100 shares today?
 Capital Evaluation

Proposed capital projects can be evaluated in several

ways.
 Present worth (PW)
 Future worth (FW)
 Annual worth (AW)
 Internal rate of return (IRR)
 External rate of return (ERR)
 Payback period (generally not appropriate as a
primary decision rule)
To be attractive, a capital project must provide a return that exceeds a
minimum level established by the organization. This minimum level is
reflected in a firm’s Minimum Attractive Rate of Return (MARR).
 Minimum Attractive Rate of Return
(MARR)

Rate of return is interest earned on your invested capital,

or commonly known as internal rate of return (IRR)
Factor to be considered in determining MARR....
 The amount of money available for
investment, and the source and cost of these
funds.
 The number of good project available for
investment and their purpose (sustain or
expand)
 The amount of perceived risk associated with
investment opportunities.
 The type of organization involved
(government, public utility or private)
 Case Study – Wal-Mart Stock

Rate of Return
 Given:
 P = $1,650
 F = $15,384576

 N = 44 years

 Find: i
 Formula to Use
 F = P(1 + i)N

 $15,384,576 = $1,650(1 + i)44

$15,384,576
 i = 23.09%

1970
2014

$1,650
 Case Study – Wal-Mart Stock

If you took out $1,650 from your If you did not invest $1,650 in
savings account and invested in Wal- Wal-Mart stock, what could you
Mart stock, you could have use your money for?
 $15,384,576
 If the best you could do was to
 Or the equivalent to earning
leave the money in a savings
23.09% interest each year on your
account to earn 6% interest over 44
savings account over 44 years.
years, you would have $21,426.
 What is the meaning of 6%
interest? This will be your
opportunity cost rate or minimum
return required for any investment.
 Case Study – Wal-Mart Stock

❑ In 1970, as long as you could earn more than a 6% interest in

another investment opportunity, you would take that
investment.
❑ Therefore, that 6% is viewed as a minimum attractive rate of
return (or required rate of return). This is the interest rate
commonly used in NPW analysis.
❑ So, to see if the proposed investment is a good one, you adopt
the following decision rule:

ROR (23.09%) > MARR(6%)

 Present Worth

The most-used method is the present worth method.

The present worth (PW) is found by discounting all cash inflows and
outflows to the present time at an interest rate that is generally the
MARR.
A positive PW for an investment project means that the project is
acceptable (it satisfies the MARR).
 Present Worth

The most-used method is the present worth method.

❑ Principle: Compute the

equivalent net surplus at n = 0
for a given interest rate of i.
❑ For Single Project Evaluation:
Accept the project if the net
surplus is positive.
❑ For Comparing Multiple
Alternatives: Select the
alternative with the largest net
present worth.
 Present Worth
𝑃𝑊 𝑖% = 𝐹0 (1 + 𝑖)0 +𝐹1 (1 + 𝑖)−1 +𝐹2 (1 + 𝑖)−2 + ⋯ + 𝐹𝑘 1 + 𝑖 −𝑘 + ⋯ + 𝐹𝑁 (1 + 𝑖)𝑁

𝑷𝑾 𝒊% = ෍ 𝑭𝒌 (𝟏 + 𝒊)−𝒌
𝒌=𝟎

i = effective interest rate, or MARR, per compounding period

k = index for each compounding period (0 < k < N)
FK = future cash flow at the end of period k
N = number of compounding periods in the planning horizon

PW Decision Rule : If PW(i = MARR) > 0, the project is economically justified

 Example 1 – Present Worth

Consider a project that has an initial investment of $50,000 and that

returns $18,000 per year for the next four years. If the MARR is 12%,
is this a good investment?

PW = -50,000 + 18,000 (P/A, 12%, 4)

PW = -50,000 + 18,000 (3.0373)

PW = $4,671.40 → This is a good investment!
 Case Study 2 – Bond Value

Bond value is a good example of present worth.

The commercial value of a bond is the PW of all future net cash flows
expected to be received : the period dividend [face value (Z) times the bond
rate (r)], and the redemption price (C), all discounted to the present at the
bond’s yield rate, i%.

𝑽𝑵 = 𝑪(𝑷Τ𝑭, 𝒊%, 𝑵) + 𝒓𝒁(𝑷Τ𝑨, 𝒊%, 𝑵)

Z = face or par value

C = redemption or disposal price (usually equal to Z)
r = bond rate (nominal interest) per interest period
N = number of periods before redemption
i = bond yield rate per period
VN = value (price) of the bond N interest periods prior to
redemption – this is a PW measure of merit
 Example 2 – Bond Value

What is the value of a 6%, 10-year bond with a par (and redemption) value of
$20,000 that pays dividends semi-annually, if the purchaser wishes to earn an
8% return?
𝑉𝑁 = 𝐶(𝑃Τ𝐹, 𝑖%, 𝑁) + 𝑟𝑍(𝑃Τ𝐴, 𝑖%, 𝑁)

VN = $20,000 (P/F, 4%, 20) + (0.03)$20,000 (P/A, 4%, 20)

VN = $20,000 (0.4564) + (0.03)$20,000 (13.5903)

VN = $17,282.18
 Exercise 1 – Bond Worth

Bill Mitselfik wants to buy a bond. It has a face value of $50,000, a bond
rate of 6% (nominal), payable semi-annually, and matures in 10 years. Bill
wants to earn a nominal interest of 8%. How much should Bill pay for the
bond?

C = Z = $50,000
𝑽𝑵 = 𝑪(𝑷Τ𝑭, 𝒊%, 𝑵) + 𝒓𝒁(𝑷Τ𝑨, 𝒊%, 𝑵)
r = 3%
𝑽𝑵 = 𝑪(𝑷Τ𝑭, 𝟒%, 𝟐𝟎) + 𝒓𝒁(𝑷Τ𝑨, 𝟒%, 𝟐𝟎)

𝑽𝑵 = 𝟓𝟎, 𝟎𝟎𝟎 𝟎. 𝟒𝟓𝟔𝟒 + 𝟎. 𝟎𝟑 𝟓𝟎, 𝟎𝟎𝟎 𝟏𝟑. 𝟓𝟗𝟎 = $𝟒𝟑, 𝟐𝟎𝟓

 Capitalized Worth

Capitalized worth is a special variation of present worth.

 Capitalized worth is the present worth of all revenues or expenses over an
infinite length of time.
 If only expenses are considered this is sometimes referred to as capitalized
cost.
 The capitalized worth method is especially useful in problems involving
endowments and public projects with indefinite lives.
 Capitalized Worth

The application of CW concepts.

The CW of a series of end-of-period uniform payments A, with interest at i% per

period, is A(P/A, i%, N). As N becomes very large (if the A are perpetual
payments), the (P/A) term approaches 1/i. So, CW = A(1/i).

(𝟏 + 𝒊)𝑵 −𝟏 𝟏
𝑪𝑾 𝒊% = 𝑷𝑾𝑵→∞ = 𝑨(𝑷ൗ𝑨, 𝒊%, ∞) = 𝑨 𝐥𝐢𝐦 = 𝑨( )
𝑵→∞ 𝒊(𝟏 + 𝒊)𝑵 𝒊
 Example 3 – Investment Pool

Option A
If $76,000 were left
$76,000(F/P,12%,4) $119,587
in the investment pool
for 4 years
Option B
If $76,000 withdrawal $35,650(F/P,1
2%,3) 1 • $49,959
from the investment $37,360(F/P, 2 • $46,864
12%,2)
pool were invested in
3 • $35,672
the project $31,850(F/P,1
2%,1)

• $34,400
Year • Amount 4

1 • $35,650
$34,400(F/P,1
2%,0) $166,896

2 • $37,360 $166,896

Investment Pool
3 • $31,850
$47,309
4 • $34,400
$119,587

PW(12%) = $47,309(P/F,12%,4) = $30.065 The net benefit of

investing in the project
 Exercise 2 – Endowment

Ahmad has decided to donate some funds to YUTP. Ahmad would like to fund an
endowment that will provide a scholarship of $25,000 each year in perpetuity, and
also a special award, “Best FYP,” each ten years (again, in perpetuity) in the amount
of $50,000. How much money does Ahmad need to donate today, in one lump sum,
to fund the endowment? Assume the fund will earn a return of 8% per year.
 Exercise 2 – Endowment

0 1 2 3 4 5 6 7 8 9 10 90 91 92 93 94 95 96 97 ∞

A=$25,000 A=$25,000

$50,000
(𝟏 + 𝒊)𝑵 −𝟏 𝟏
𝑪𝑾 𝒊% = 𝑷𝑾𝑵→∞ = 𝑨(𝑷ൗ𝑨, 𝒊%, ∞) = 𝑨 𝐥𝐢𝐦 = 𝑨( )
𝑵→∞ 𝒊(𝟏 + 𝒊)𝑵 𝒊
0 1 2 3 4 5 6 7 8 9 10 90 91 92 93 94 95 96 97 ∞

A=$25,000 + $50,000(A/F,8%,10)=$28,450

𝟏
𝑪𝑾 = $𝟐𝟖, 𝟒𝟓𝟎 = $𝟑𝟓𝟓, 𝟔𝟐𝟓
𝟎. 𝟎𝟖
 Future Worth

Future Worth (FW) method is an alternative to the PW method.

 Looking at FW is appropriate since the primary objective is to maximize
the future wealth of owners of the firm.
 FW is based on the equivalent worth of all cash inflows and outflows at
the end of the study period at an interest rate that is generally the
MARR.
 Decisions made using FW and PW will be the same.
 Future Worth

Future Worth (FW) method is an alternative to the PW method. $47,309

❑ Given
Cash flows and MARR (i)
❑ Find
The net equivalent worth at a
specified period other than the $37,360
$35,560 $31,850 $34,400
“present,” commonly at the end
of the project life 0
❑ Decision Rule 1 2 3
Accept the project if the
equivalent worth is positive.
$76,000
Project life

FW Decision Rule : If FW(i = MARR) > 0, the project is economically justified

 Example 4– Automation

Future worth example.

A $45,000 investment in a new conveyor system is projected to improve throughput
and increasing revenue by $14,000 per year for five years. The conveyor will have
an estimated market value of $4,000 at the end of five years. Using FW and a
MARR of 12%, is this a good investment?

A=$14,000 $4,000

0 1 2 3 4 5

$45,000
𝐹𝑊 = −$45,000(𝐹 Τ𝑃, 12%, 5) + $14,000(𝐹 Τ𝐴, 12%, 5) + $4,000
𝐹𝑊 = −$45,000 1.762 + $14,000 6.353 + $4,000
𝐹𝑊 = −$79,290 + $88,942 + $14,000 = $13,652
Good investment!!!
 Annual Worth

Annual Worth (AW) is another way to assess projects.

 Type equation here.Annual worth is an equal periodic series of dollar
amounts that is equivalent to the cash inflows and outflows, at an
interest rate that is generally the MARR.
 The AW of a project is annual equivalent revenue or savings (R) minus
annual equivalent expenses (E), less its annual capital recovery (CR)
amount.
❑ By knowing the annual equivalent worth, we can:
o Seek consistency of report format.
o Determine the unit cost (or unit profit).
o Facilitate the unequal project life comparison.

AW Decision Rule : If AW(i = MARR) > 0, the project is economically justified

 Capital Recovery

Capital recovery reflects the capital cost of the asset.

 CR is the annual equivalent cost of the capital invested.
 The CR covers the following items.
 Loss in value of the asset.
 Interest on invested capital (at the MARR).

 The CR distributes the initial cost (I) and the salvage value (S) across
the life of the asset.

𝑪𝑹 𝒊% = 𝑰(𝑨Τ𝑷, 𝒊%, 𝑵) − 𝑺(𝑨Τ𝑭, 𝒊%, 𝑵)

 Capital (ownership) Cost

Capital recovery reflects the capital cost of the asset.

 Def: Owning equipment associated
with two transactions— S
(1) its initial cost (I), and 0
(2) its salvage value (S). N
 Capital costs: Taking these items into
consideration, we calculate the capital
costs as: I

𝑪𝑹 𝒊% = 𝑰(𝑨Τ𝑷, 𝒊%, 𝑵) − 𝑺(𝑨Τ𝑭, 𝒊%, 𝑵) 0 1 2 3 N

𝑪𝑹 𝒊% = (𝑰 − 𝑺)(𝑨Τ𝑷, 𝒊%, 𝑵) + 𝒊𝑺
CR(i)
 Example 5 – Drive Away
SEGMENT BEST MODELS ASKING PRICE AFTER 3
PRICE YEARS
Compact car Mini Cooper $19,800 $12,078
Midsize car Volkswagen $28,872 $15,013
Passat
Sports car Porsche 911 $87,500 $48,125
Comp Luxury car BMW 3 Series $39,257 $20,806
Luxury car Mercedes CLK $51,275 $30,765
Minivan Honda Odyssey $26,876 $15,051
Subcompact SUV Honda CR-V $20,540 $10,681
Compact SUV Acura MDX $37,500 $21,375
Full size SUV Toyota Sequoia $37,842 $18,921
Compact truck Toyota Tacoma $21,200 $10,812
Full size truck Toyota Tundra $25,653 $13,083

Determine the CR of an Altis 1.8G purchased in 2014 for RM120,000 with resale
value of RM 65,000. (assume 6% interest). If monthly instalment is RM 1500,
should you sell it?
 Example 6 – Annual Worth
An off grid solar project requires an initial investment of $45,000, has a
salvage value of $12,000 after six years, incurs annual expenses of $6,000,
and provides an annual revenue of $18,000. Using a MARR of 10%,
determine the AW of this project.
 Example 6 – Annual Worth
$12,000
AR=$18,000

0 1 2 3 4 5 6

$45,000
AE=$6,000

𝑪𝑹 𝒊% = (𝑰 − 𝑺)(𝑨Τ𝑷, 𝒊%, 𝑵) + 𝒊𝑺
𝑪𝑹 𝒊% = (𝟒𝟓, 𝟎𝟎𝟎 − 𝟏𝟐, 𝟎𝟎𝟎)(𝑨Τ𝑷, 𝟏𝟎%, 𝟔) + 𝟎. 𝟏(𝟏𝟐, 𝟎𝟎𝟎)
𝑪𝑹 𝒊% = 𝟑𝟑, 𝟎𝟎𝟎 𝟎. 𝟐𝟐𝟗𝟔 + 𝟏, 𝟐𝟎𝟎 = 𝟖, 𝟕𝟕𝟕

𝑨𝑾 = 𝟏𝟖, 𝟎𝟎𝟎 − 𝟔, 𝟎𝟎𝟎 − 𝟖. 𝟕𝟕𝟕 = $𝟑, 𝟐𝟐𝟑 Good investment!!!

 Rate of Return (ROR)

Rate of return can be defined in a number of ways.

 Interest rate earned on the unpaid (outstanding) balance of an
installment loan.
 The break-even interest rate which equates the present worth of a
project’s cash outflows to the present worth of its cash inflows
 the interest rate earned on the unrecovered project balance of the
investment such that when the project terminates, the unrecovered
project balance will be zero
 Example 7 – Loan Repayment
A bank lends $10,000 and receives an annual repayment of $4,021 over 3
years. The bank is said to earn a return of 10% on its loan of $10,000.

A = $10,000 (A/P, 10%, 3)

= $4,021

Unpaid Loan Return on Payment Unpaid Loan

Balance at Unpaid Received Balance at
n Beginning of Year Balance (10%) from Borrower End of Year

0 $0 $0 -$10,000 -$10,000
1 -$10,000 -$1,000 +$4,021 -$6,979
2 -$6,979 -$698 +$4,021 -$3,656
3 -$3,656 -$366 +$4,021 $0

A return of 10% on the amount still outstanding at the beginning

of each year
 Internal Rate of Return

 The internal rate of return (IRR) method is the most widely used rate of
return method for performing engineering economic analysis.
 It is also called the investor’s method, the discounted cash flow method,
and the profitability index.
 If the IRR for a project is greater than the MARR, then the project is
acceptable.

IRR Decision Rule : If IRR > MARR, the project is economically justified
 Internal Rate of Return

How the IRR works

 The IRR is the interest rate that equates the equivalent worth of an
alternative’s cash inflows (revenue, R) to the equivalent worth of cash
outflows (expenses, E).
 The IRR is sometimes referred to as the breakeven interest rate.

The IRR is the interest i'% at which

𝑁 𝑁

𝑃𝑊 = ෍ 𝑅𝑘 𝑃Τ𝐹 , 𝑖 ′ %, 𝑘 − ෍ 𝐸𝑘 𝑃Τ𝐹 , 𝑖 ′ %, 𝑘 = 0
𝑘=0 𝑘=0
 Internal Rate of Return
160,000 160,000 160,000 160,000 50,000

MARR = 10%

500,000
𝑁 𝑁

𝑃𝑊 = ෍ 𝑅𝑘 𝑃Τ𝐹 , 𝑖 ′ %, 𝑘 − ෍ 𝐸𝑘 𝑃Τ𝐹 , 𝑖 ′ %, 𝑘 = 0
𝑘=0 𝑘=0

−500,000 + 160,000 𝑃Τ𝐹 , 𝑖 ′ %, 1 + 𝑃Τ𝐹 , 𝑖%, 2 + 𝑃Τ𝐹 , 𝑖 ′ %, 3 + 𝑃Τ𝐹 , 𝑖 ′ %, 4 + 50,000 𝑃Τ𝐹 , 𝑖 ′ %, 5 = 0

If i’ = 10%
−500,000 + 160,000 0.9091 + 0.8264 + 0.7513 + 0.6830 + 50,000(0.6209) = 38,213

If i’ = 15%
−500,000 + 160,000 0.8696 + 0.7561 + 0.6575 + 0.5718 + 50,000 0.4972 = −18,340

Interpolate, i’ = 13.3% > MARR

 Internal Rate of Return

Solving for the IRR is a bit more complicated than PW, FW, or AW
 The method of solving for the i'% that equates revenues and expenses
normally involves trial-and-error calculations, or solving numerically
using mathematical software.
 The use of spreadsheet software can greatly assist in solving for the IRR.
Excel uses the IRR(range, guess) or RATE(nper, pmt, pv) functions.
 Excel 1 – Present Value

❑ Find: Internal Rate of Return

A B C
Period 1 Period Cash Flow
Cash
(N) 2
Flow
3 0 -1000
0 -$1,000 4 1 -500
5 2 800
1 -500 6 3 1500
2 800 7 4 2000
8
3 1,500 9 IRR = 44%
10
4 2,000 11

=IRR(cell range, guess) =IRR(B3:B7,10%)

 Example 5-13 - IRR

A piece of new equipment has been proposed by engineers to increase the productivity of a
certain manual welding operation. The investment cost is $25,000, and the equipment will have
a market (salvage) value of $5,000 at the end of its expected life of five years. Increased
productivity attributable to the equipment will amount to $8,000 per year after extra operating
costs have been subtracted from the value of the additional production. Evaluate the IRR of the
proposed equipment. Is the investment a good one? Recall that the MARR is 20% per year.
5,000
MARR=20%
8,000 80,000 80,000 8,000 8,000

𝑁 𝑁

25,000 𝑃𝑊 = ෍ 𝑅𝑘 𝑃Τ𝐹 , 𝑖 ′ %, 𝑘 − ෍ 𝐸𝑘 𝑃Τ𝐹 , 𝑖 ′ %, 𝑘 = 0

𝑘=0 𝑘=0
 Example 5-13 - IRR

If i’ = 20%
8,000 𝑃Τ𝐹 , 𝑖 ′ %, 1 + 𝑃Τ𝐹 , 𝑖%, 2 + 𝑃Τ𝐹 , 𝑖 ′ %, 3 + 𝑃Τ𝐹 , 𝑖 ′ %, 4 + 𝑃Τ𝐹 , 𝑖 ′ %, 5 + 5,000(𝑃Τ𝐹 , 𝑖 ′ %, 5) − 25,000 = 0

8,000 0.8333 + 0.6944 + 0.5787 + 0.4823 + 0.4019 + 5,000 0.4019 − 25,000 = 934

If i’ = 25%
8,000 𝑃Τ𝐹 , 𝑖 ′ %, 1 + 𝑃Τ𝐹 , 𝑖%, 2 + 𝑃Τ𝐹 , 𝑖 ′ %, 3 + 𝑃Τ𝐹 , 𝑖 ′ %, 4 + 𝑃Τ𝐹 , 𝑖 ′ %, 5 + 5,000(𝑃Τ𝐹 , 𝑖 ′ %, 5) − 25,000 = 0

8,000 0.8000 + 0.6400 + 0.5120 + 0.4096 + 0.3277 + 5,000 0.3277 − 25,000 = −1,847

Interpolate, i’ = 21.6% > MARR

 Internal Rate of Return
Challenges in applying the IRR method.
 It is computationally difficult without proper tools.
 In rare instances multiple rates of return can be found.
(See Appendix 5-A.)
 The IRR method must be carefully applied and interpreted when
comparing two more mutually exclusive alternatives (e.g., do not
directly compare internal rates of return).
 External Rate of Return

Reinvesting revenue—the External Rate of Return (ERR)

 The IRR assumes revenues generated are reinvested at the IRR—which

may not be an accurate situation.
 The ERR takes into account the interest rate, ε, external to a project at
which net cash flows generated (or required) by a project over its life
can be reinvested (or borrowed). This is usually the MARR.
 If the ERR happens to equal the project’s IRR, then using the ERR and
IRR produce identical results.
 External Rate of Return
The ERR procedure
 Discount all the net cash outflows to time 0 at ε% per compounding
period.
 Compound all the net cash inflows to period N at at ε%.
 Solve for the ERR, the interest rate that establishes equivalence between
the two quantities.
ERR is the i'% at which

where
Rk = excess of receipts over expenses in period k,
Ek = excess of expenses over receipts in period k,
N = project life or number of periods, and
ε = external reinvestment rate per period.

ERR Decision Rule : If ERR > MARR, the project is economically justified
 Example 6– Cash Flow

Applying the ERR method

For the cash flows given below, find the ERR when the external
reinvestment rate is ε = 12% (equal to the MARR).
Year 0 1 2 3 4
Cash Flow -$15,000 -$7,000 $10,000 $10,000 $10,000

Expenses

Revenue

Solving, we find
 Example 5-17 - ERR

A piece of new equipment has been proposed by engineers to increase the productivity of a
certain manual welding operation. The investment cost is $25,000, and the equipment will have
a market (salvage) value of $5,000 at the end of its expected life of five years. Increased
productivity attributable to the equipment will amount to $8,000 per year after extra operating
costs have been subtracted from the value of the additional production. Evaluate the IRR of the
proposed equipment. Is the investment a good one? Recall that the MARR is 20% per year.
5,000
MARR=20%
8,000 80,000 80,000 8,000 8,000

25,000
25,000 𝐹 Τ𝑃 , 𝑖 ′ %, 5 = 8,000 𝐹 Τ𝐴 , 20%, 5 + 5,000 = 64,532.80
64,532.80
𝑃Τ𝐹 , 𝑖 ′ %, 5 = = 2.5813 = (1 + 𝑖 ′ )5
25,000
𝑖 ′ = 20.88% > 𝑀𝐴𝑅𝑅
 Payback Period

The payback period method is simple, but possibly misleading.

 The simple payback period is the number of years required for cash
inflows to just equal cash outflows.
 It is a measure of liquidity rather than a measure of profitability.

The payback period is the smallest value of θ (θ ≤ N) for which the

relationship below is satisfied.
𝐼
Ɵ=
𝐴

For discounted payback future cash flows are discounted back to the
present, so the relationship to satisfy becomes
 Payback Period

Problems with the payback period method.

 It doesn’t reflect any cash flows occurring after θ, or θ'.
 It doesn’t indicate anything about project desirability except the
speed with which the initial investment is recovered.
 Recommendation: use the payback period only as supplemental
information in conjunction with one or more of the other
methods in this chapter.
 Payback of 3 years or less are often desired.
 Example 7– Payback Period

Finding the simple and discounted payback period for a set of cash
flows.
End of Net Cash Cumulative Cumulative
 The cumulative cash Year Flow PW at 0% PW at 6%
flows in the table were
calculated using the 0 -$42,000 -$42,000 -$42,000
formulas for simple and
discounted payback. 1 $12,000 -$30,000 -$30,679

2 $11,000 -$19,000 -$20,889

 From the calculations θ
= 4 years and θ' = 5
3 $10,000 -$9,000 -$12,493
years.
4 $10,000 $1,000 -$4,572

5 $9,000 $2,153
 Example 7– Payback Period

Finding the simple and discounted payback period for a set of cash
flows.
$12,000
$11,000
$10,000 $10,000 $9,000

0 1 2 3 4 5

$42,000

𝑘 = 1, 𝑃𝑊 = $12,000 − $42,000 = −$30,000

𝑘 = 2, 𝑃𝑊 = $12,000 + $11,000 − $42,000 = −$19,000
𝑘 = 3, 𝑃𝑊 = $12,000 + $11,000 + $10,000 − $42,000 = −$9,000
𝑘 = 4, 𝑃𝑊 = $12,000 + $11,000 + $10,000 + $10,000 − $42,000 = $1,000

Payback Period = 4 years

 Example 7– Payback Period

Finding the simple and discounted payback period for a set of cash
flows.
$12,000
$11,000 (𝑃Τ𝐹, 6%, 1) = 0.9434
$10,000 $10,000 $9,000
(𝑃Τ𝐹, 6%, 2) = 0.8900
(𝑃Τ𝐹, 6%, 3) = 0.8396
0 1 2 3 4 5 (𝑃Τ𝐹, 6%, 4) = 0.7921
(𝑃Τ𝐹, 6%, 5) = 0.7473
$42,000
𝑘 = 1, 𝑃𝑊 = 12,000 0.9434 − 42,000 = −$30,679
𝑘 = 2, 𝑃𝑊 = 12,000 0.9434 + (11,000)(0.8900) − $42,000 = −$20,889
𝑘 = 3, 𝑃𝑊 = 12,000 0.9434 + 11,000 0.8900 + (10,000)(0.8396) − $42,000 = −$12,493
𝑘 = 4, 𝑃𝑊 = 12,000 0.9434 + 11,000 0.8900 + 10,000 0.8396 + 10,000 0.7921 − $42,000
= −$4,572
𝑘 = 5, 𝑃𝑊 = 12,000 0.9434 + 11,000 0.8900 + 10,000 0.8396 + 10,000 0.7921
+(9,000)(0.7473) − $42,000 = $2,154
Payback Period = 5 years
 Summary
50

 Evaluation of project capital expenditure must use

appropriate methods of project worth and rate of return.

 Present worth, Future worth, Capital recoveries, minimum

rate of returns and payback period are methods/formulae to
assist in deciding worthiness of any project.