(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
.
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