Payback period analysis

Payback period analysis is a useful tool in

the project professional's toolbox. According to the
payback period concept, a viable project is one that
is able to pay back the original investment as early
as possible. The payback period is achieved at that
point in time when cumulative cash inflows more
than offset cumulative outflows, or to phrase it in
common-sense terms: When we are finally making
more money in total than we have spent in total.
The importance of payback period is that it
indicates when, from an investment perspective,
we are finally out of the woods. Projects that take a
long time to achieve payback are less attractive
than those that achieve quick payback. For one
thing, they tie up capital for a long time, not
enabling it to be used for other productive
purposes. For another, they are generally riskier
than those with short payback periods because
over a long stretch of time, many things can go
wrong.
Table 1 shows costs and revenues
associated with two projects over a five-year period
of time. In both cases, $500 is being spent and
$1,300 is being earned over the five years.
However, the two projects experience payback at
different times. In Project A, payback occurs in
Year 2, at which point cumulative expenses ($400)
are covered by cumulative revenues ($400). In
Project B, payback occurs in Year 4, at which time

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cumulative expenses ($400) are more than
covered by cumulative revenues ($800).

TABLE 1
Project A
Cumulative Cumulative
Year Outflows outflows Inflows inflows
1 200 200
2 200 400 300 400
3 500 300 700
4 0 500 300
5 0 500 300 1300
Total 500 1300

Project B
Cumulative Cumulative
Year Outflows outflows Inflows inflows
1 200 200
2 200 400 200
3 500 200 400
4 0 500 400 800
5 0 500 500 1300
Total 500 1300

When viewed from a payback perspective,

Project A is more attractive than Project B. For
one thing, by achieving payback earlier, Project A
has funds that can be released after Year 2 to
exploit other investment opportunities, whereas
Project B does not reach this point until after Year
4. For another, Project A is less risky than B in the
sense

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that we can determine early in the five year time
frame whether it is able to pay for itself, whereas this
determination cannot be made on Project B until
Year 4.

During the late Americans

experienced inflation rates in the 17% per annum
range. If at the beginning of 1978, you told a
customer that you could do a job for him for
$10,000, you found that you would be spending
about $11,700 on the job if you didn't get around to
doing it at the end of the year. With a 17% inflation
rate, $10,000 on January I,1978 had roughly the
same purchasing power as about $11,700 on
December 31.
Inflation provides one example of what is
called the time value of money, a concept that
suggests that a dollar today has a different value
than a dollar one year from now. There is more
to time value of money than the force of inflation.
Consider a hypothetical situation where there is no
inflation, so a dollar on January 1 has the same
purchasing power as a dollar 12 months later on
December 31 of the year. If you have an opportunity
to lend $1,000 to a business at a 10% per annum
interest rate, then you would receive a payment of
$1,100 at the end of the year when the loan is
paid off. Your initial investment of $1,000 has
grown by 10% over time.

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FUTURE VALUE OF MONEY

When you look at money that you control

today and take into account how much it will be
worth some time in the future, you are assessing the
value of money. A good example of future
value of money that is routinely computed in our
daily lives is the compound interest you gain when
you put money into a savings account or certificate
of deposit. Let's say you put $100,000 into a
certificate of deposit that earns you 10% of interest
income per year over a five-year period of time. The
value of your CD will grow year-by-year in the
following way (for purposes of simplicity, we are
assuming only one compounding point each year):

End of Year 1: $100,000 x 10% $110,000

End of Year 2: $110,000 x 10% $121,000
End of Year 3: $121,000 x 10% $133,100
End of Year 4: $133,100 x 10% $146,410
End of Year 5: $146,410 x $161,051

The formula that provides these results is:

where FV = future value

= payment at the outset (time zero)
i = prevailing interest rate
n = the number of time periods

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 Future value looks at a cash flow today and
projects its value at some time in the future. You
routinely carry out this type of computation when you
put money into a savings account or CD. However,
let's say you are concerned with the reverse
process. A friend who has borrowed $16,105 from
you informs you that she cannot repay you until five
years from now. If the prevailing interest rate you
face is 10% you have the opportunity to put
your money into a 10% CD), you can compute from
the data offered above that $16,105 five years from
now is equal to $10,000 today, because you can
take the $10,000, invest it at and have $16,105
in your account five years from now. (Note that in
finance, what we call the prevailing interest is
given the name cost of capital.)
When you look at a future cash flow and
assess it in terms of today's money, are
conducting a present value analysis. Note that it is
the reverse process of future value analysis. In fact,
the formula for conducting present value analysis is
the same as the formula used in computing future
value with its terms rearranged slightly. That is:

Present value = =

Table 2 shows present value computations for

cash outflows, inflows, and net flows associated with
two hypothetical five year projects, Project A and

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Project B. It assumes a prevailing interest rate of
10% year-by-year.

The bottom line for Project A is:

Total present value, cash outflows = $422.24

Total present value, cash inflows = $955.42
Total present value, net flows = $533.18

and the bottom line for Project B is:

Total present value, cash outflows $422.24

Total present value, cash inflows = $907.48
Total present value, net flows = $485.24

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 TABLE 2
Project A
Present Present Present
value of value of value of net
Yea Outflows outflows Inflows inflows Net flows flows
rI $200.00 $181.82 $100.00 $90.91 (590.91)
2 $200.00 $165.29 $300.00 $247.93 $100.00 $82.64
3 $100.00 $75.13 $300.00 $225.39 $200.00 $150.26
4 $0.00 $0.00 $300.00 $204.90 $300.00 $204.90
5 $0.00 $0.00 $300.00 $186.28 $300.00 $186.28
$500.00 $422.24 $7,300.00 $955.42 $800.00 $533.18

Project
Present Present
Cumulative value of value of net
Year Outflows outflows Inflows inflows Net flows flows
1 $200.00 $181.82 $100.00 $90.91 ($90.91)
2 $200.00 $165.29 $100.00 $82.64 ($82.64)
3 $100.00 $75.13 $200.00 $150.26 $100.00 $75.13
4 $0.00 $0.00 $400.00 $273.21 $400.00 $273.21
5 $0.00 $0.00 $500.00 $310.46 $500.00 $310.46
Total $500.00 $422.24 $907.48 $800.00 $485.24

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UMT
 The present value associated with net flows is
an important concept in finance and is given the
name netpresent value (NPV). A little thought
shows that NPV is the present value of profit. When
seen from this perspective, we conclude that once
present values have been computed for the different
cash flows, Project A is more attractive than Project
B, because its true, discounted profit ($533.18) is
greater than the discounted profit of Project B
($485.24). Note that before carrying out the present
value analysis, Project A and Project B have the
same level of profitability. In both cases, "raw" profit
is $800, so it appears that A and B are equally
attractive from the purview of profit. However, the
present value analysis - which factors in the
time value of money - makes it clear that A is
actually
more attractive than B.
When you look at present values for different
values in a cash outflow or inflow stream, you are
conducting what is called discounted cash flow
(DCF) analysis.
NPV offers us a crude decision rule when
trying to determine whether or not a potential project
is worthy of support. The rule states that if NPV is
positive, the project will be profitable, and therefore it
is a possible candidate for support. If it is negative,
the project will lose money and should not be
supported.
How does one actually compute present
value? If you work with Excel spreadsheets, you can
use the NPV function to calculate present values. It

14 2003 UMT
is easy to use. Let's say you feel the prevailing
interest rate you will be facing over the next five
years is 4.7%. In computing project costs, you
estimate that in Year 1 of the project, you will have
a
$300,000 outlay, in Year 2, a $243,000 outlay,
and in Year 3, a $125,000 outlay. If you type in the
following Excel function, you will obtain the
present value of the cash flow for the three years:

Alternatively, you will find tables in most

business finance books that provide present value
coefficients for different interest rates. For example,
the coefficient for a cash flow 5 years from now
when the prevailing interest rate is 5% is 0.78.
Present value can be determined by taking the
target cash value and multiplying it by the
coefficient. Thus if you will be receiving a payment
of
$10,000 five years from now, that is the same as
receiving a payment of $7,800 today if the prevailing
interest rate over the five years is 5%.

INTERNAL RATE OF RETURN

If you know nothing about internal rate of

except for its name, you have an important
piece of intelligence. The fact that IRR computes
some kind of rate tells you must be
reported in percentage or decimal terms. For
example, if a colleague says to you: "Our IRR last
year was about
$95,000," you that she has got it wrong,
because she is reporting a dollar figure and not
a
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percent. However, if this same colleague says to
you: "Our IRR last year was at least she
has got the units of analysis correct even if the
number she reports is wrong.
IRR is a measure of return on investment. It
is, in fact, one of several such measures, return
on assets and return on equity. As such, IRR
provides you with a sense of the "bang for the
of an investment. If one of your team members
computes that the IRR associated with a specific
project investment is 12% over a five year period
of time, he is telling you that each dollar you invest
in the project generates 12 cents of return each
year. Is this good? To answer this question, you
need to compare the anticipated project IRR figure
with the rates of return you might encounter with
other investment opportunities. For example, the
12% figure is higher than T-bill rates
CD rates the interest rate on a checking
account 1 and the anticipated rate of
return on Project C 9.5%). The fact that it is so
much higher than the alternatives makes this an
attractive investment opportunity - at least from
the
financial perspective.
With IRR, we examine cash outflows and
inflows for a fixed period of time five years).
With a typical investment, you spend money in the
early time periods and make little or nothing in
return. As time goes on, the balance shifts if the
investment is paying off. By the later time periods,
your cash outflows may have ceased and you are

16 2003
making strong returns. In computing IRR, we are
calculating your average performance, year-by-year
(or month-by-month, or whatever other units of
analysis you are using), for the fixed time period
you are working with.
Table 3 illustrates IRR computations for
Projects A and B. Note that both projects have the
same NPV of $99.96. So from the perspective of
"real" profit, the two projects are indistinguishable.
However, because Project has cash outflows
occurring later than Project A, it has a higher IRR.
Basically, the IRR figure of 23% is saying: "Select
me. I am spending money later than Project A,
when money is 'cheaper,' so I have a better rate of
return. Project A is spending money early, when
money is dear."

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 TABLE
3

Year Year
1 $200.00 $0.00 $200.00 1

2 $200.00 $0.00 $200.00 2

$100.00 $100.00 $0.00 3

$0.00 $200.00 $200.00 4
5 $0.00 $500.00 $500.00
Total Total
Present Present
value $422.24 $522.19 $99.96 value
Interest Interest
rate rate
IRR 19% IRR

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Table 4 offers insight into how IRR is actually computed. The table is
comprised of three sub- tables, each of which has identical dollar values in the
main body of the table. The only difference among the tables is that the present
values are different, reflecting different interest rates. The first sub-table shows
that NPV is $99.96 when the interest rate is 10%. The second shows that NPV
drops to $37.80 when NPV is increased to 15%. The third shows that NPV
becomes -8.17 when the interest rate is raised to reflecting a situation
where the project is actually losing money.
Somewhere between the 15% and 20% interest rate, the project goes from a
money-making to a money-losing scenario. The actual breakeven point occurs
when the interest rate is 19%. At this point, NPV is zero. The 19% figure is the
IRR.
If a project's anticipated IRR is lower than the prevailing interest rate, it
doesn't make sense to invest in it. You would be better putting your money
into some other investment vehicle where the returns are higher. This is what
has occurred in Table 4 in the scenario where the prevailing interest rate is
yet IRR is 19%.