Beruflich Dokumente
Kultur Dokumente
Year
0
1
2
3
Cash Flow
-$500,000
$200,000
$300,000
$200,000
Present Value
-$500,000
$181,818.18
$247,933.88
$150,262.96
When solving for the NPV of the formula, this new project would be estimated to be a
valuable venture.
Payback Period
The payback period formula is used to determine the length of time it will take to recoup the
initial amount INVESTED on a project or investment. The payback period formula is used
for quick calculations and is generally not considered an end-all for evaluating whether to
invest in a particular situation.
The result of the payback period formula will match how often the cash flows are received.
An example would be an initial outflow of $5,000 with $1,000 cash inflows per month. This
would result in a 5 month payback period. If the cash inflows were paid annually, then the
result would be 5 years.
At times, the cash flows will not be equal to one another. If $10,000 is the
initial INVESTMENT and the cash flows are $1,000 at year one, $6,000 at year two,
$3,000 at year three, and $5,000 at year four, the payback period would be three years as
the first three years are equal to the initial outflow.
formula for the net present value method may be used to close this information gap in order
to properly evaluate the best choice.
However, it is worth mentioning that although the net present value method may be
preferable to determine long term profitability, the payback period formula helps with cash
flow analysis for short term budgeting. Suppose a situation where investment X has a net
present value of 10% more than its initial investment and investment Y has a net present
value of triple its initial investment. At first glance, investment Y may seem the reasonable
choice, but suppose that the payback period for investment X is 1 year and investment Y is
10 years. Investment Y could cause problems if the investment is needed sooner. An
analogy of this would be like banks where maintaining cash flows of their
investments(loans) is vital to their business.
Another issue with the formula for period payback is that it does not factor in the time value
of MONEY . The time value of money concept, as it applies to the payback period formula,
proposes that each future cash flow is worth less when compared to today's value. The
discounted payback period formula may be used instead to consider the time value of
money, however the discounted payback period formula takes away the benefit of making
quick calculations.
The present value of annuity formula determines the value of a series of future periodic
payments at a given time. The present value of annuity formula relies on the concept of
time value of money, in that one dollar present day is worth more than that same dollar at
a future date.
As with any FINANCIAL formula that involves a rate, it is important to make sure that the
rate is consistent with the other variables in the formula. If the payment is per month, then
the rate needs to be per month, and similarly, the rate would need to be the annual rate if
the payment is annual.
An example would be an annuity that has a 12% annual rate and payments are made
monthly. The monthly rate of 1% would need to be used in the formula.
Assumptions
The formula shown has assumptions, in that it must be an ordinary annuity. These
assumptions are that
1) The periodic payment does not change
2) The rate does not change
3) The first payment is one period away
If the payment and/or rate changes, the calculation of the present value would need to be
adjusted depending on the specifics. If the payment increases at a specific rate, the present
value of a growing annuity formula would be used.
If the first payment is not one period away, as the 3rd assumption requires, the present
value of annuity due or present value of deferred annuity may be used. An annuity due is an
annuity that's initial payment is at the beginning of the annuity as opposed to one period
away. A deferred annuity pays the initial payment at a later time.
The present value of a series of payments, whether the payments are the same or not, is
When the periodic payments or dividends are all the same, this is considered a geometric
series. By using the geometric series formula, the formula can be rewritten as
The P's in the numerator can be factored out of the fraction and become 1. The 1's in the
denominator of the formula are subtracted from one another. After making these
adjustments, the formula is simplified to the present value of annuity formula shown on the
top of the page.
The equivalent annual annuity formula is used in capital budgeting to show the net present
value of an INVESTMENT as a series of equal cash flows for the length of the INVESTMENT
. The net present value(NPV) formula shows the present value of an investment that has
uneven cash flows. When comparing two different INVESTMENTS using the net present
value method, the length of the investment (n) is not taken into consideration. An
investment with a 15 year term may show a higher NPV than an investment with a 4 year
term. By showing the NPV as a series of cash flows, the equivalent annual annuity formula
provides a way to factor in the length of an investment.
An example of how the equivalent annual annuity formula may be useful is comparing
twonew projects where one project has a 15 year term and the other has a 4 year term.
Assume that both projects have the same NPV. The 4 year project will receive
the returnsooner so it will show a higher cash flow when using the equivalent annual
annuity formula. In real life, comparing two INVESTMENTS will not always be so obvious
and the formula should be applied.
Another way of explaining the usefulness of the equivalent annual annuity formula is that
an INVESTMENT with a shorter life span can be reinvested and the earnings on the
reinvestment is not taken into consideration when using the NPV formula. The equivalent
annual annuity formula provides a comparison relative to time which eliminates the need for
considering reinvestment with the same earnings as the current investment.
Using the prior example of comparing one project with a 4 year term and another project
with a 15 year term, the NPV of the 4 year project is $100,000 and the NPV of the 15 year
project is $150,000. The rate used for both is 8%. Putting the variables of the 4 year
project in the equivalent annual annuity formula shows
The discounted payback period formula is used to calculate the length of time to recoup
anINVESTMENT based on the INVESTMENT'S discounted cash flows. By discounting each
individual cash flow, the discounted payback period formula takes into consideration the
time value of money.
The discounted payback period formula is used in capital budgeting to compare a project or
projects against the cost of the investment. The simple payback period formula can be used
as a quick measurement, however discounting each cash flow can provide a moreaccurate
picture of the investment. As a simple example, suppose that an initial cost of a project is
$5000 and each cash flow is $1,000 per year. The simple payback period formula would be
5 years, the initial investment divided by the cash flow each period. However, the
discounted payback period would look at each of those $1,000 cash flows based on its
present value. Assuming the rate is 10%, the present value of the first cash flow would be
$909.09, which is $1,000 divided 1+r. Each individual cash flow would then be discounted
to its present value until it is determined how long it would take to recoup the original
$5,000.
which results in a discounted payback period of 7.273. Although this formula calculates
results with decimals, it is important to consider that there may be a slight difference due to
rounding and more importantly, that there may not be a such thing as a partial cash inflow.
This may warrant rounding up to determine how long it would take to recoup the
initial INVESTMENT .
This is not as much a formula, as a way of explaining that the discounted cash flow method
discounts each inflow until net present value equals zero.
Another method to simplify the calculation when cash flows are even is to use a table for
the present value of annuity factor in order to solve n. The need to solve for n in the present
value of annuity formula will be further explained in the following section.