Payback Period

Definition of PBP
According to L. J. Gitman, Payback period is the exact amount of the time required for the firm
to recover its initial investment in a project as calculated from cash inflows.

Decision Criteria:
i. PBP > Project Life = Accepted.
ii. PBP = Project Life = May be Accepted.
iii. PBP < Project Life = Rejected.

Calculation of PBP:
1. When cash flows are even,
PBP=

A
B

Where,
A=Net cash invested
B= Net cash flow for each Period.

Problem (a): Jordan Enterprises is considering a capital expenditure that requires an initial
investment of $42000 and returns after-tax cash inflows of $7000 per year for 10 years. The firm
has a maximum acceptable PBP of 8 years. What is the PBP of the project? Should the company
accept the project or not?
Answer:
We know that,
PBP = A/B

Where,

A = Net cash invested = $42000

B = Net Cash Flow for Each Period = $7000

So, PBP = 42000/7000

= 7 Years

As the actual PBP is less than maximum acceptable PBP, the company should accept the project.
2. When cash flows are uneven / mixed,
PBP=A +

B
C

Where,
A = Year in which the cumulative cash flow is near
to the net cash invested.
B = Cumulative cash flow of year A
C = Cash flow of the following year of the year A

Problem (b): Bill Williamson has the opportunity to invest in Project A that costs $9000 today
and provides yearly payment of $2200, $2500, $2500, $2000, and $1800 over 5 years. Or Bill
can invest in Project A that costs $9000 today and provides yearly payment of $1500, $1500,
$1500, $3500 and $4000 over 5 years. Calculate PBP of both projects, which project he should
invest using Payback Method?
Schedule of Cash flow of Project A
Year
0
1
2
3 (A)
4
5

Cash flow ($)

-9000
2200
2500
2500
2000 (C)
1800

So PBP for Project A,

PBP=A +

PBP=3+

B
C

|1800|
2000

PBP=3+0.9
PBP=3.9Years

Cumulative Cash flow ($)

-9000
-6800
-4300
-1800 (B)
200
2000

Schedule of Cash flow of Project B

Year
0
1
2
3
4 (A)
5

Cash flow ($)

-9000
1500
1500
1500
3500
4000 (C)

Cumulative Cash flow ($)

-9000
-7500
-6000
-4500
-1000 (B)
3000

So PBP for Project A,

PBP=A +

B
C

|1000|

PBP=4 +

4000

PBP=4 +0.25
PBP=4.25 Years
Although Bill would get more Cash in Project B after 5 years. But as his choices are on the basis
of Payback Method, he will choose Project A because it has lower PBP.

Net Present Value (NPV)

Definition of NPV:
The Net Present Value equals the present value of the cash inflows minus the present value of
cash out flows with the cost of capital used as a discount rate.
So NPV = Total discounted cash inflows Initial investment

Equation to Solve NPV:

n

NPV =
i=1

Or,
NPV =

CF n
(1+i)n

CF 1
1

(1+ i)

CF 0

CF 2
2

(1+i)

CF 3
(1+i)3

+CF 0

Here,
CFn = Cash inflow of year n
i = Interest rate / Discount Rate / Cost of Capital
CF0 = Initial Investment

Steps in Calculating NPV:

When cash inflows are mixed,
1. Calculate cash inflows after tax.
2. Discount them with rate of interest.
3. Calculate NPV using the equation.

Decision Criteria:
NPV>0 = Accepted
NPV<0 = Rejected
Higher NPV = Accepted
Lower NPV = Rejected
Problem (C): Neil Corporation has two projects under consideration. Initial investment is
$40,000 for each of them. The cash flows for each project are shown in the following table.
The firm has a 16% cost of capital. What are the Net Present Value of 3 Projects? Which
Project should be choosen?
4

Year
1
2
3
4
5

Project A
7000
10000
13000
16000
19000

Project B
19000
16000
13000
10000
7000

Project C
13000
13000
13000
13000
13000

Answer:
Schedule of Cash Inflow of Project A
Year
n
1
2
3
4
5

Cash Inflow
Discount factor
CFn
(1+i)n
7000
(1+0.16)1 = 1.16
10000
(1+0.16)2 = 1.3456
13000
(1+0.16)3 = 1.5608
16000
(1+0.16)4 = 1.8106
19000
(1+0.16)5 = 2.1003
Total Discounted Cash Inflow

Discounted Cash Inflow

CFn / (1+i)n
6034.48
7431.63
8328.55
8836.66
9046.15
39677.47

So, NPVA = 39,677.47 40,000 = -322.53

Schedule of Cash Inflow of Project B
Year
n
1
2
3
4
5

Cash Inflow
Discount factor
CFn
(1+i)n
19000
(1+0.16)1 = 1.16
16000
(1+0.16)2 = 1.3456
13000
(1+0.16)3 = 1.5608
10000
(1+0.16)4 = 1.8106
7000
(1+0.16)5 = 2.1003
Total Discounted Cash Inflow

Discounted Cash Inflow

CFn / (1+i)n
16379.31
11890.61
8328.55
5523.03
3332.86
45454.36

So, NPVB = 45454.36 40,000 = 5454.36

Schedule of Cash Inflow of Project B
Year
n
1
2
3
4
5

Cash Inflow
Discount factor
CFn
(1+i)n
13000
(1+0.16)1 = 1.16
13000
(1+0.16)2 = 1.3456
13000
(1+0.16)3 = 1.5608
13000
(1+0.16)4 = 1.8106
13000
(1+0.16)5 = 2.1003
Total Discounted Cash Inflow

So, NPVC = 42565.81-40000 = 2565.81

Project B Should be chosen as it has highest NPV.
5

Discounted Cash Inflow

CFn / (1+i)n
11206.89
9661.12
8328.55
7179.78
6189.47
42565.81

Internal Rate of Return (IRR)

Definition of Internal Rate of Return (IRR):

Internal rate of return is defined as the discount rate which equals the aggregate present value
of the net cash inflows with the aggregate present value of cash outflows of the project.

Decision Criteria:
i. IRR>Cost of Capital =Accepted.
ii. IRR< Cost of Capital = Rejected.

Calculation of IRR:
1. When cash flows are even,

i. Calculate discount factor by using following equation

Discount Factor=

Investment Required
Net Annual Cash Flow

ii. Compute the discount factor with PVIF table and calculate IRR.

Problem (D):
Kingsway Airways Can buy an additional Air Jet for $40000 that will provide $ 13000 of Annual Net
Cash Inflow for 5 years. Calculate the IRR. If cost of capital for Kingsway Airways is 13% , what
would be the project acceptance decision?
Answer:
We know that,

Discount Factor =

So , DF =

Investment Required
Net Annual Cash Flow

40000
13000

So , DF =3.076
So , PVIFA IRR ,5 years =3.076
6

So , PVIFA 18 , 5 years=3.127
So , PVIFA 19 , 5 years=3.058
So , PVIFA 20 , 5 years=3.2 .991
So, IRR = 19% [ 3.058

is the closest to 3.076]

Project will be accepted because IRR (19%) is greater than Cost of Capital (14%)

2. When cash flows are uneven / mixed,

i. At first calculate Net annual cash inflow or Average annual cash inflow.
ii. Imagine an IRR in which NPV may become 0 or near 0.
iii. Conduct trial.
iv. If NPV<0, then calculate NPV with higher IRR imagined. If NPV>0, then calculate NPV with
lower IRR imagined.
v. Do this trial and error till we get discount rate for both positive and negative NPV
vi. Calculate actual IRR by using this calculation,

IRR= A+

C
(B A)
CD
Where,
A=Lower discount rate.
B=Higher discount rate
C=NPV of A.
D=NPV of B.

Problem (E):
Bell Manufacturing is attempting to choose the better of two mutually exclusive projects. Their
cost of capital is 15% and the relevant cash inflows for the projects are following:

Project X
$500000

Initial Investment
Year (n)
1
2
3
4
5

Project Y
$325000
Cash Inflows (CFn)

100000
120000
150000
190000
250000

140000
120000
95000
70000
50000

Answer:
Since net cash flows are uneven, we need to imagine discount rate for the calculation of NPV = 0.
When Discount Factor is 16% then NPV for Project X:
Annual Cash flow
(500000)
100000
120000
150000
190000
250000

Discount Factor
1.00
0.862
0.743
0.641
0.552
0.476

Discounted Annual Cash Flow

(500000)
86200
89160
96150
104880
119000
NPV
4610
Since net present value is positive figure, we need to decrease discount rate. When Discount Factor
is 15% then NPV for Project X:
Annual Cash flow
(500000)
100000
120000
150000
190000
250000

Discount Factor
1
0.869
0.756
0.658
0.572
0.497

NPV
Since we have both positive and negative net present value,

IRR= A+

C
(B A)
CD

IRR=15+

9250
(1615)
92504610

IRR=15+ 0.667
IRR=15.667

Discounted Annual Cash Flow

(500000)
86900
90720
98700
108680
124250
(9250)

Since the IRRx is greater than Cost of Capital it can be accepted.

Since net cash flows are uneven, we need to imagine discount rate for the calculation of NPV = 0.
When Discount Factor is 18% then NPV for Project Y:
Annual Cash flow
(325000)
140000
120000
95000
70000
50000

Discount Factor
1.00
0.847
0.718
0.609
0.516
0.437

Discounted Annual Cash Flow

(325000)
118580
86160
57855
36120
21850
NPV
4435
Since net present value is positive figure, we need to decrease discount rate. When Discount Factor is
17% then NPV for Project Y:
Annual Cash flow
(325000)
140000
120000
95000
70000
50000

Discount Factor
1.00
0.855
0.731
0.624
0.534
0.456

NPV
Since we have both positive and negative net present value,

IRR= A+

Discounted Annual Cash Flow

(325000)
119700
87720
59280
37380
22800
(1880)

C
(B A)
CD

IRR=1 7+

1880
(1 81 7)
18804 435

IRR=17 +0. 298

IRR=17.298

Since Project Y has higher IRR, so Project Y will be chosen.

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