Payback Period =

Initial Investment
Cash Inflow per Period

When cash inflows are uneven, we

need to calculate the cumulative
net cash flow for each period and
then use the following formula for
payback period:

Payback Period = A +

B
C

In the above formula,

A is the last period with a
negative cumulative cash flow;
cumulative cash flow at the
end of the period A;
C is the total cash flow during
the period after A
Both of the above situations are
applied in the following examples.

Decision Rule
Accept the project only if its
payback period is LESS than the
target payback period.

Examples
Example
1:isEven
CashtoFlows
Company C
planning
undertake a project requiring initial
investment of $105 million. The
project is expected to generate
$25 million per year for 7 years.
Calculate the payback period of the
project.
Solution
Payback Period = Initial
Investment Annual Cash Flow =
$105M $25M = 4.2 years
Example
2:isUneven
Company C
planningCash
to Flows
undertake another project
requiring initial investment of $50
million and is expected to generate
$10 million in Year 1, $13 million in
Year 2, $16 million in year 3, $19
million in Year 4 and $22 million in
Year 5. Calculate the payback
value of the project.
Solution

(cash flows in millions)

Year
0
1
2

Cash Flow
-50
10
13

3
4
5
Payback Period
= 3 + (|-$11M| $19M)
= 3 + ($11M $19M)
3 + 0.58
3.58 years

Disadvantages
Advantages of payback period
are:
1. Payback period is very simple
to
calculate.
inherent
in a project. Since cash
flows that occur later in a
project's life are considered
more uncertain, payback period
provides an indication of how
certain the project cash inflows
are.
3. For companies facing liquidity
problems, it provides a good
ranking of projects that would
return money early.
Disadvantages
of payback period
are:
1. Payback period does not take
into account the time value of
money which is a serious
drawback since it can lead to
wrong decisions. A variation of
payback method that attempts
to remove this drawback is
calleddiscounted payback
period method.
2. It does not take into account,
the cash flows that occur after
the payback period.

16
19
22

Cumulative
Cash Flow
-50
-40
-27

-11
8
30

Example 2: Uneven Cash Inflows: An initial investment of $8,320

thousand on plant and machinery is expected to generate cash inflows of
$3,411 thousand, $4,070 thousand, $5,824 thousand and $2,065
thousand at the end of first, second, third and fourth year respectively. At
the end of the fourth year, the machinery will be sold for $900 thousand.
Calculate the net present value of the investment if the discount rate is
18%. Round your answer to nearest thousand dollars.
Solution

PV Factors:

Year 1 = 1 (1 + 18%)^1 0.8475

Year 2 = 1 (1 + 18%)^2 0.7182

Year 3 = 1 (1 + 18%)^3 0.6086

Year 4 = 1 (1 + 18%)^4 0.5158

The rest of the calculation is summarized below:

Year
Net Cash Inflow
Salvage Value
Total Cash Inflow
Present Value Factor
Present Value of Cash Flows
Total PV of Cash Inflows
Initial Investment
Net Present Value

Strengths and Weaknesses of NPV

Strengths

Net present value accounts for time value of money which makes it a
sounder approach than other investment appraisal techniques which do
not discount future cash flows such payback period and accounting rate of
return.

Net present value is even better than some other discounted cash flows
techniques such as IRR. In situations where IRR and NPV give conflicting
decisions, NPV decision should be preferred.

Weaknesses

NPV is after all an estimation. It is sensitive to changes in estimates for

future cash flows, salvage value and the cost of capital.

Net present value does not take into account the size of the project. For
example, say Project A requires initial investment of $4 million to generate
NPV of $1 million while a competing Project B requires $2 million
investment to generate an NPV of $0.8 million. If we base our decision on
NPV alone, we will prefer Project A because it has higher NPV, but Project
B has generated more shareholders wealth per dollar of initial investment
($0.8 million/$2 million vs $1 million/$4 million).

Example
Find the IRR of an investment having initial cash outflow of $213,000. The
cash inflows during the first, second, third and fourth years are expected
to be $65,200, $96,000, $73,100 and $55,400 respectively.
Solution
Assume that r is 10%.
NPV at 10% discount rate = $18,372
Since NPV is greater than zero we have to increase discount rate, thus
NPV at 13% discount rate = $4,521
But it is still greater than zero we have to further increase the discount
rate, thus
NPV at 14% discount rate = $204
NPV at 15% discount rate = ($3,975)

Since NPV is fairly close to zero at 14% value of r, therefore

IRR 14%

2
$3,411

$4,070

$3,411
0.8475
$2,890.68
$10,888
8,320
$2,568

$4,070
0.7182
$2,923.01

thousand

3
$5,824
$5,824
0.6086
$3,544.67

4
$2,065
900
$2,965
0.5158
$1,529.31

rofitability Index
=

Explanation:

Profitability index is actually a

modification of the net present
value method. While present
value is an absolute measure
(i.e. it gives as the total dollar
figure for a project), the
profibality index is a relative
measure (i.e. it gives as the
figure as a ratio).

Decision Rule

Present Value of Future Cash Flows

Initial Investment Required

1+

Net Present Value

Initial Investment Required

Accept a project if the

profitability index is greater
than 1, stay indifferent if the
profitability index is zero and
don't accept a project if the
profitability index is below 1.

Profitability index is sometimes

called benefit-cost ratio too and
is useful in capital rationing
since it helps in ranking
projects based on their per
dollar return.

Example

Company C is undertaking a
project at a cost of $50 million
which is expected to generate
future net cash flows with a
present value of $65 million.
Calculate the profitability index.
Solution

Profitability Index = PV of
Future Net Cash Flows / Initial
Investment Required

Profitability Index = $65M /

$50M = 1.3

Net Present Value = PV of Net

Future Cash Flows Initial
Investment Rquired

Net Present Value = $65M$50M = $15M.

The information about NPV and

initial investment can be used
to calculate profitability index
as follows:

Profitability Index = 1 + (Net

Present Value / Initial
Investment Required)

Profitability Index = 1 + $15M/

$50M = 1.3

nt Required

Here is an example of
a cash budget for a
small business:

SMALL BUSINESS
CASH BUDGET

For the three months

ending March 31,
200x
Item

Beginning cash
balance

Jan

Feb

March

15,000

-13,500

20,000

Cash Sales

20,000

25,000

30,000

Collection of
accounts
receivable

45,000

55,000

70,000

Expected Cash
Receipts:

Other income

5,000

80,000

66,500

125,000

50,000
10,400

11,000
10,400

5,000
10,400

2,000

2,000

2,000

10,000

Selling expense

6,000

8,000

6,000

Administrative
expense

4,500

4,500

4,500

10,000

10,000

10,000

600

600

600

93,500

46,500

38,500

Total cash
collected

Expected cash
payments:

Raw materials (or

inventory)
Payroll

Other direct
expenses
Advertising

Plant and
equipment
expenditures

Other payments

Total cash
expenses

Cash surplus (or

deficit)

-13,500*

20,000*

86,500