Definition of PBP
According to L. J. Gitman, Payback period is the exact amount of the time required for the firm
to recover its initial investment in a project as calculated from cash inflows.
Decision Criteria:
i. PBP > Project Life = Accepted.
ii. PBP = Project Life = May be Accepted.
iii. PBP < Project Life = Rejected.
Calculation of PBP:
1. When cash flows are even,
PBP=
A
B
Where,
A=Net cash invested
B= Net cash flow for each Period.
Problem (a): Jordan Enterprises is considering a capital expenditure that requires an initial
investment of $42000 and returns after-tax cash inflows of $7000 per year for 10 years. The firm
has a maximum acceptable PBP of 8 years. What is the PBP of the project? Should the company
accept the project or not?
Answer:
We know that,
PBP = A/B
Where,
As the actual PBP is less than maximum acceptable PBP, the company should accept the project.
2. When cash flows are uneven / mixed,
PBP=A +
B
C
Where,
A = Year in which the cumulative cash flow is near
to the net cash invested.
B = Cumulative cash flow of year A
C = Cash flow of the following year of the year A
Problem (b): Bill Williamson has the opportunity to invest in Project A that costs $9000 today
and provides yearly payment of $2200, $2500, $2500, $2000, and $1800 over 5 years. Or Bill
can invest in Project A that costs $9000 today and provides yearly payment of $1500, $1500,
$1500, $3500 and $4000 over 5 years. Calculate PBP of both projects, which project he should
invest using Payback Method?
Schedule of Cash flow of Project A
Year
0
1
2
3 (A)
4
5
PBP=3+
B
C
|1800|
2000
PBP=3+0.9
PBP=3.9Years
B
C
|1000|
PBP=4 +
4000
PBP=4 +0.25
PBP=4.25 Years
Although Bill would get more Cash in Project B after 5 years. But as his choices are on the basis
of Payback Method, he will choose Project A because it has lower PBP.
NPV =
i=1
Or,
NPV =
CF n
(1+i)n
CF 1
1
(1+ i)
CF 0
CF 2
2
(1+i)
CF 3
(1+i)3
+CF 0
Here,
CFn = Cash inflow of year n
i = Interest rate / Discount Rate / Cost of Capital
CF0 = Initial Investment
Decision Criteria:
NPV>0 = Accepted
NPV<0 = Rejected
Higher NPV = Accepted
Lower NPV = Rejected
Problem (C): Neil Corporation has two projects under consideration. Initial investment is
$40,000 for each of them. The cash flows for each project are shown in the following table.
The firm has a 16% cost of capital. What are the Net Present Value of 3 Projects? Which
Project should be choosen?
4
Year
1
2
3
4
5
Project A
7000
10000
13000
16000
19000
Project B
19000
16000
13000
10000
7000
Project C
13000
13000
13000
13000
13000
Answer:
Schedule of Cash Inflow of Project A
Year
n
1
2
3
4
5
Cash Inflow
Discount factor
CFn
(1+i)n
7000
(1+0.16)1 = 1.16
10000
(1+0.16)2 = 1.3456
13000
(1+0.16)3 = 1.5608
16000
(1+0.16)4 = 1.8106
19000
(1+0.16)5 = 2.1003
Total Discounted Cash Inflow
Cash Inflow
Discount factor
CFn
(1+i)n
19000
(1+0.16)1 = 1.16
16000
(1+0.16)2 = 1.3456
13000
(1+0.16)3 = 1.5608
10000
(1+0.16)4 = 1.8106
7000
(1+0.16)5 = 2.1003
Total Discounted Cash Inflow
Cash Inflow
Discount factor
CFn
(1+i)n
13000
(1+0.16)1 = 1.16
13000
(1+0.16)2 = 1.3456
13000
(1+0.16)3 = 1.5608
13000
(1+0.16)4 = 1.8106
13000
(1+0.16)5 = 2.1003
Total Discounted Cash Inflow
Decision Criteria:
i. IRR>Cost of Capital =Accepted.
ii. IRR< Cost of Capital = Rejected.
Calculation of IRR:
1. When cash flows are even,
Investment Required
Net Annual Cash Flow
ii. Compute the discount factor with PVIF table and calculate IRR.
Problem (D):
Kingsway Airways Can buy an additional Air Jet for $40000 that will provide $ 13000 of Annual Net
Cash Inflow for 5 years. Calculate the IRR. If cost of capital for Kingsway Airways is 13% , what
would be the project acceptance decision?
Answer:
We know that,
Discount Factor =
So , DF =
Investment Required
Net Annual Cash Flow
40000
13000
So , DF =3.076
So , PVIFA IRR ,5 years =3.076
6
So , PVIFA 18 , 5 years=3.127
So , PVIFA 19 , 5 years=3.058
So , PVIFA 20 , 5 years=3.2 .991
So, IRR = 19% [ 3.058
Project will be accepted because IRR (19%) is greater than Cost of Capital (14%)
IRR= A+
C
(B A)
CD
Where,
A=Lower discount rate.
B=Higher discount rate
C=NPV of A.
D=NPV of B.
Problem (E):
Bell Manufacturing is attempting to choose the better of two mutually exclusive projects. Their
cost of capital is 15% and the relevant cash inflows for the projects are following:
Project X
$500000
Initial Investment
Year (n)
1
2
3
4
5
Project Y
$325000
Cash Inflows (CFn)
100000
120000
150000
190000
250000
140000
120000
95000
70000
50000
Answer:
Since net cash flows are uneven, we need to imagine discount rate for the calculation of NPV = 0.
When Discount Factor is 16% then NPV for Project X:
Annual Cash flow
(500000)
100000
120000
150000
190000
250000
Discount Factor
1.00
0.862
0.743
0.641
0.552
0.476
Discount Factor
1
0.869
0.756
0.658
0.572
0.497
NPV
Since we have both positive and negative net present value,
IRR= A+
C
(B A)
CD
IRR=15+
9250
(1615)
92504610
IRR=15+ 0.667
IRR=15.667
Discount Factor
1.00
0.847
0.718
0.609
0.516
0.437
Discount Factor
1.00
0.855
0.731
0.624
0.534
0.456
NPV
Since we have both positive and negative net present value,
IRR= A+
C
(B A)
CD
IRR=1 7+
1880
(1 81 7)
18804 435
10