L14: Evaluating Business and

Engineering Assets – Part II

ECON 320 Engineering Economics

Mahmut Ali GOKCE
Industrial Systems Engineering
Computer Sciences

www.izmirekonomi.edu.tr
Payback Period

Lecture No.14

www.izmirekonomi.edu.tr
Chapter 5
Present-Worth Analysis
 Loan versus Project
Cash Flows
 Initial Project Screening
Methods
 Present-Worth Analysis
 Methods to Compare
Mutually Exclusive
Alternatives

www.izmirekonomi.edu.tr
Chapter Opening Story – Federal Express

Nature of Project:
 Equip 40,000 couriers
with PowerPads
 Save 10 seconds per
pickup stop
 Investment cost: $150
million
 Expected savings: $20
million per year
Federal Express

www.izmirekonomi.edu.tr
Ultimate Questions

 Is it worth investing $150 million to save $20

million per year, say over 10 years?
 How long does it take to recover the initial
investment?
 What kind of interest rate should be used in
evaluating business investment
opportunities?

www.izmirekonomi.edu.tr
 Mr. Bracewell’s Investment Problem

• Built a hydroelectric plant using his personal savings of $800,000

• Power generating capacity of 6 million kwhs

• Estimated annual power sales after taxes - $120,000

• Expected service life of 50 years

•
Was Bracewell's $800,000 investment a wise one?

•How long does he have to wait to recover his initial investment,

and will he ever make a profit?

www.izmirekonomi.edu.tr
Mr. Brcewell’s Hydro Project

www.izmirekonomi.edu.tr
Bank Loan vs. Investment Project

•
Bank Loan
Loan
Bank Customer

Repayment

•
Investment Project
Investment

Company Project
Return

www.izmirekonomi.edu.tr
Describing Project Cash Flows
Year Cash Inflows Cash Net
(n) (Benefits) Outflows Cash Flows
(Costs)
0 0 $650,000 -$650,000

1 215,500 53,000 162,500

2 215,500 53,000 162,500

… … … …

8 215,500 53,000 162,500

www.izmirekonomi.edu.tr
Payback Period
 Principle:
How fast can I recover my initial investment?
 Method:
Based on cumulative cash flow (or accounting
profit)
 Screening Guideline:
If the payback period is less than or equal to
some specified payback period, the project
would be considered for further analysis.
 Weakness:
Does not consider the time value of money
www.izmirekonomi.edu.tr
 Fails to measure profitability. Assumes no
profit made during payback period.
 Does not consider the timing of the cashflows
What if –10000, 9000, 500, 500 vs. –10000, 500,
500, 9000
Same payback, very different situation

www.izmirekonomi.edu.tr
Example 5.1 Payback Period

N Cash Flow Cum. Flow

0 -$105,000+$20,000 -$85,000
1 $35,000 -$50,000
2 $45,000 -$5,000
3 $50,000 $45,000
4 $50,000 $95,000
5 $45,000 $140,000
6 $35,000 $175,000

Payback period should occurs somewhere

between N = 2 and N = 3.
www.izmirekonomi.edu.tr
 $45,000 $45,000
$35,000 $35,000
Annual cash flow $25,000
$15,000
0
1 2 3 4 5 6
Years

$85,000

150,000
Cumulative cash flow ($)

100,000 3.2 years

Payback period
50,000

0
-50,000

-100,000

0 1 2 3 4 5 6
Years (n)
www.izmirekonomi.edu.tr
Practice Problem

 How long does it take to recover the initial

investment for Federal Express?

 How long does it take to recover the

investments made by Mr. Bracewell from his
hydroelectric project?

www.izmirekonomi.edu.tr
Discounted Payback Period
 Principle:
How fast can I recover my initial investment
plus interest?
 Method:
Based on cumulative discounted cash flow
 Screening Guideline:
If the discounted payback period (DPP) is less
than or equal to some specified payback period,
the project would be considered for further
analysis.
 Weakness:
Cash flows occurring after DPP are ignored
www.izmirekonomi.edu.tr
Example 5.2 Discounted Payback Period Calculation
Period Cash Flow Cost of Funds Cumulative
(15%)* Cash Flow
0 -$85,000 0 -$85,000

1 15,000 -$85,000(0.15) = -$12,750 -82,750

2 25,000 -$82,750(0.15) = -12,413 -70,163

3 35,000 -$70,163(0.15) = -10,524 -45,687

4 45,000 -$45,687(0.15) =-6,853 -7,540

5 45,000 -$7,540(0.15) = -1,131 36,329

6 35,000 $36,329(0.15) = 5,449 76,778

* Cost of funds = (Unrecovered beginning balance) X (interest rate)

www.izmirekonomi.edu.tr
Summary

Payback periods can be used as a screening

tool for liquidity, but we need a measure of
investment worth for profitability.

www.izmirekonomi.edu.tr