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(Chapter 4 - Olson) ISDS 4113 10. Given the following data, estimate payback, net present value, and cost/benefit ratio. Use a discount rate of 10% per year. Time Outflow Inflow Begin year 1 \$10,000 \$0 End year 1 \$5,000 \$6,000 End year 2 \$3,000 \$7,000 End year 3 \$1,000 \$8,000 Answer: First, we need to calculate the net cash flow for each year (Inflow – Outflow): Time Outflow Inflow Net Cashflow Begin year 1 \$10,000 \$0 (Initial investment) End year 1 \$5,000 \$6,000 \$1,000 (\$6,000 - \$5,000) End year 2 \$3,000 \$7,000 \$4,000 (\$7,000 - \$3,000) End year 3 \$1,000 \$8,000 \$7,000 (\$8,000 - \$1,000) To calculate payback : Payback is the length of time (in years/months) it will take to recover your investment in the project. Since the “annual savings” (the positive net cashflow) is a different amount each year, we cannot use the simple formula shown in the slides (Payback period = Project Cost/Annual Savings). Instead, we need to look year-by-year to determine when the total savings = project cost (\$10,000): o At the end of year 1, total savings = \$1,000 o At the end of year 2, total savings = \$5,000 (\$1,000 + \$4,000) o At the end of year 3, total savings = \$12,000 (\$1,000 + \$4,000 + \$7,000) This means that the “breakeven point” is somewhere during year 3. If we assume that the net cashflow was a steady amount during year 3 then the number of months to recover the remaining \$5,000 of project costs during year 3 would be \$5,000/\$7000 = .7 years. So the estimated payback period is 2.7 years . 1

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