Investment Appraisal

Payback Period
◦ Under payback method, an investment project is accepted or rejected on the basis of payback
period.
◦ Payback period means the period of time that a project requires to recover the money
invested in it. It is mostly expressed in years.
◦ According to payback method, the project that promises a quick recovery of initial investment
is considered desirable. If the payback period of a project is shorter than or equal to the
management’s maximum desired payback period, the project is accepted, otherwise rejected.
◦ For example, if a company wants to recoup the cost of a machine within 5 years of purchase, the
maximum desired payback period of the company would be 5 years. The purchase of machine would
be desirable if it promises a payback period of 5 years or less.
Payback Period
◦ When net annual cash inflow is even (i.e., same cash flow every period), the payback period of the project can be
computed by applying the simple formula given below:
Payback Period
◦ The Delta company is planning to purchase a machine known as machine X. Machine X would cost $25,000 and
would have a useful life of 10 years with zero salvage value. The expected annual cash inflow of the machine is
$10,000.
◦ Required: Compute payback period of machine X and conclude whether or not the machine would be purchased
if the maximum desired payback period of Delta company is 3 years.
◦ Solution:
Since the annual cash inflow is even in this project, we can simply divide the initial investment by the annual cash
inflow to compute the payback period. It is shown below:
Payback period = $25,000/$10,000
= 2.5 years
According to payback period analysis, the purchase of machine X is desirable because its payback period is 2.5
years which is shorter than the maximum payback period of the company.
Payback Period
Due to increased demand, the management of Rani Beverage Company is considering to purchase a new equipment to
increase the production and revenues. The useful life of the equipment is 10 years and the company’s maximum desired
payback period is 4 years. The inflow and outflow of cash associated with the new equipment is given below:
Initial cost of equipment: $37,500
Annual cash inflows:
Sales: $75,000
Annual cash Outflows:
Cost of ingredients: $45,000
Salaries expenses: $13,500
Maintenance expenses: $1,500
Non cash expenses:
Depreciation expense: $5,000
Required: Should Rani Beverage Company purchase the new equipment? Use payback method for your answer.
Payback Period
Solution:
Step 1: In order to compute the payback period of the equipment, we need to workout the net annual cash flow by
deducting the total of cash outflow from the total of cash inflow associated with the equipment.
Computation of net annual cash inflow:
$75,000 – ($45,000 + $13,500 + $1,500)
= $15,000
Step 2: Now, the amount of investment required to purchase the equipment would be divided by the amount of net annual
cash inflow (computed in step 1) to find the payback period of the equipment.
= $37,500/$15,000
=2.5 years
Depreciation is a non-cash expense and has therefore been ignored while calculating the payback period of the project.
According to payback method, the equipment should be purchased because the payback period of the equipment is 2.5
years which is shorter than the maximum desired payback period of 4 years.
Payback Period
Comparison of two or more alternatives – choosing from several alternative projects:
◦ Where funds are limited and several alternative projects are being considered, the project with the shortest
payback period is preferred. It is explained with the help of the following example:

The management of Health Supplement Inc. wants to reduce its labor cost by installing a new machine. Two types
of machines are available in the market – machine X and machine Y. Machine X would cost $18,000 where as
machine Y would cost $15,000. Both the machines can reduce annual labor cost by $3,000.
Required: Which is the best machine to purchase according to payback method?
Solution:
Payback period of machine X: $18,000/$3,000 = 6 years
Payback period of machine y: $15,000/$3,000 = 5 years
According to payback method, machine Y is more desirable than machine X because it has a shorter payback period
than machine X.
Payback Period
◦ Payback method with uneven cash flow:
◦ In the previous examples we have assumed that the projects generate even cash inflow but many projects usually
generate uneven cash flow. When projects generate inconsistent or uneven cash inflow (different cash inflow in
different periods), the simple formula cannot be used to compute payback period. In such situations, we need to
compute the cumulative cash inflow and then apply the following formula:
Payback Period
An investment of $200,000 is expected to generate the following cash inflows in six years:
Year 1: $70,000
Year 2: $60,000
Year 3: $55,000
Year 4: $40,000
Year 5: $30,000
Year 6: $25,000
Required: Compute payback period of the investment. Should the investment be made if management wants to
recover the initial investment in 3 years or less?
Payback Period
Solution:
Because the cash inflow is uneven, the payback period formula cannot be used to compute the payback period. We
can compute the payback period by computing the cumulative net cash flow as follows:

Payback period = 3 + (15,000*/40,000)

= 3 + 0.375
= 3.375 Years

*Unrecovered investment at start of 4th year:

= Initial cost – Cumulative cash inflow at the end of 3rd year
= $200,000 – $185,000
= $15,000
The payback period for this project is 3.375 years which is longer than
the maximum desired payback period of the management (3 years). The
investment in this project is therefore not desirable.
Average rate of
return (ARR)
◦ The term “average rate of return” refers to the
percentage rate of return that is expected on
an investment or asset from the initial
investment cost or average investment over
the life of the project.
◦ ‘Return’ is another term for net cash flow.
Businesses can easily compare different
investments using this calculation. Generally,
businesses will prefer investments with a
higher rate of return.
◦ The formula for average rate of return is
derived by dividing the average profit by the
initial investment (or capital cost) and then
expressed in terms of percentage.
 This formula can be broken down into three steps:

How to
Step 1. Calculate the total net cash flow (returns) over the lifetime of
calculate ARR the investment minus the capital cost.
Step 2. Divide the result from Step 1 by the number of years of the
project.
Step 3. Divide the result from Step 2 by the project’s initial
investment cost. Convert this number into a percentage by
multiplying by 100.
 ◦ Suppose the purchase of a new computer system that
costs $350,000 is forecast to generate the following net
cash flows over the next five years (when it needs to be
replaced):
Year 1 $100,000
Year 2 $130,000
Year 3 $180,000
Year 4 $150,000
Year 5 $100,000

Example ◦ There are several steps to calculate the ARR for this
project:
◦ Total net cash inflow over the five years is $660,000
◦ Projected profit = $660,000 minus $350,000 (for the
capital cost) = $310,000
◦ Divide by the years of use = $310,000 / 5 years =
$62,000 per year
◦ Divide by the capital cost = $62,000 / $350,000 =
17.7%
Payback period and average rate of return
◦ Study the information in the table below and then answer the questions that follow

Net Cash Flow

Year
Project Atlanta ($) Project Boston ($)
0 (140,000) (140,000)
1 80,000 60,000
2 60,000 60,000
3 20,000 60,000
◦ Calculate the payback period for both projects and comment on your findings
◦ Calculate the average rate of return on both projects. Assuming that the savings interest rate is 4.75%, comment
on your findings
◦ Considering all relevant factors, examine which investment project is more attractive
 ◦ Net present value (NPV) is the difference
between the present value of cash inflows and
the present value of cash outflows over a
period of time.
◦ NPV = Sum or present values – Cost of
investment
Net Present
Value
Net Present Value
◦ Discounting is the reverse of calculating compound interest. A discount factor is used to
convert the future net cash flow to its present value today.
◦ As an example, suppose an organization expects to receive $100,000 in three year’s time whilst
today’s interest rate is 5%. What is the present value of $100,000?
◦ From the table, we can see that the discount factor for 5% interest over 3 years is 0.8638.
Hence, the present value of the $100,000 received in 3 year’s time is $86,380
◦ The NPV is the sum of all discounted cash flows minus the cost of a particular investment
project
NPV = Sum of present values – Cost of investment
 ◦ The net cash flow in each year is simply the
total cash inflow minus the total cash outflow,
i.e. $150,000 minus $50,000 = $100,000
Example:

Suppose that new Period Net Cash Discount Present

mechanisation for a firm is Flow Factor Value
estimated to cost $300,000 Year 1 100,000 0.9524 95,240
and should last for five years. Year 2 100,000 0.9070 90,700

It will cost an estimated Year 3 100,000 0.8638 86,380

$50,000 per annum to Year 4 100,000 0.8227 82,270
maintain but will increase the Year 5 100,000 0.7835 78,350
value of the firm’s output by
an estimated $150,000. Total 500,000 432940

Interest rates are currently

5%. Calculate the NPV on the ◦ Add the total present value figures and minus
proposed investment. the initial investment cost
NPV = $432,940 - $300,000 = $132,940