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 e, GE Park Copyright © 2016, Pearson Education, Ltd. 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 e, GE Park Copyright © 2016, Pearson Education, Ltd. 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 e, GE Park Copyright © 2016, Pearson Education, Ltd. All Rights Reserved

Bank Loan vs. Project Cash Flows Contemporary Engineering Economics, 6 e, GE Park Copyright

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 e, GE Park Copyright © 2016, Pearson Education, Ltd. All Rights Reserved

Cash Flow Diagram for the Computer Process Control Project Contemporary Engineering Economics, 6 e,

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 e, GE Park Copyright © 2016, Pearson Education, Ltd. 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 e, GE Park Copyright © 2016, Pearson Education, Ltd. 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 Contemporary Engineering Economics, 6 e, GE Park 3 4 5 Years (n) 6 Copyright © 2016, Pearson Education, Ltd. 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 e, GE Park Copyright © 2016, Pearson Education, Ltd. 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 e, GE Park Copyright © 2016, Pearson Education, Ltd. 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 e, GE Park Copyright © 2016, Pearson Education, Ltd. All Rights Reserved

Illustration of Discounted Payback Period Contemporary Engineering Economics, 6 e, GE Park Copyright ©

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 e, GE Park Copyright © 2016, Pearson Education, Ltd. All Rights Reserved