Project Screening Method Payback Period Lecture No 15
Project Screening Method – Payback Period Lecture No. 15 Chapter 5 Contemporary Engineering Economics Copyright © 2016 Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved
Chapter Opening Story: Building a New Football Stadium for Colorado State University CSU unveils a new $246 million stadium expansion plan. Goal • Attract better football players to win more games. • Attract more out-of-state students Desired project outcome • Raise the university profile and increase tuition revenue to make up the shortfall from state funding. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved
Ultimate Questions • CSU’ s Point of View – Would there be enough demand for their football tickets to justify the investment required in new facilities and marketing? – What would be the potential financial risk if the actual demand is far less than its forecast or tuition revenue from out -of-state students is too low? – If everything goes as planned, how long does it take to recover the initial investment? Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved
Bank Loan vs. Project Cash Flows Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved
Example 5. 1: Describing Project Cash Flows: A Computer-Process Control Project Year (n) Cash Inflows (Benefits) 0 0 1 Cash Outflows (Costs) Net Cash Flows $650, 000 -$650, 000 215, 500 53, 000 162, 500 2 215, 500 53, 000 162, 500 … … 8 215, 500 53, 000 162, 500 Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved
Cash Flow Diagram for the Computer Process Control Project Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved
Payback Period q Principle How fast can I recover my initial investment? q Method Based on the cumulative cash flow (or accounting profit) q Screening Guideline If the payback period is less than or equal to some specified bench-mark period, the project would be considered for further analysis. q Weakness Does not consider the time value of money Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved
Example 5. 3: Payback Period N Cash Flow Cum. Flow 0 1 2 3 4 5 6 −$105, 000+$20, 000 $15, 000 $25, 000 $35, 000 $45, 000 $35, 000 −$85, 000 −$70, 000 −$45, 000 −$10, 000 $35, 000 $80, 000 $115, 000 Payback period should occurs somewhere between N = 3 and N = 4. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved
Annual cash flow $35, 000 $45, 000 $35, 000 $25, 000 $15, 000 0 1 2 Years 3 4 5 6 Cumulative cash flow ($) $85, 000 150, 000 3. 2 years Payback period 100, 000 50, 000 0 -50, 000 -100, 000 0 1 2 3 Contemporary Engineering Economics, 6 th edition Park 4 5 Years (n) 6 Copyright © 2016 by Pearson Education, Inc. All Rights Reserved
Practice Problem • How long does it take to recover the initial investment for the computer process control system project in Example 5. 1? Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved
Discounted Payback Period q Principle How fast can I recover my initial investment plus interest? q Method Based on the cumulative discounted cash flow q Screening Guideline If the discounted payback period (DPP) is less than or equal to some specified bench-mark period, the project could be considered for further analysis. q Weakness Cash flows occurring after DPP are ignored Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved
Discounted Payback Period Calculation Period (n) Cash Flow (An) 0 −$85, 000 1 Cost of Funds (15%)* Ending Cash Balance 0 −$85, 000 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) Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved
Illustration of Discounted Payback Period Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved
Summary • Payback periods can be used as a screening tool for liquidity, but we need a measure of investment worth for profitability. • To consider the project profitability, we need to consider the time value of money of project cash flows over the entire life of the project. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved
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