Advantages and disadvantages of payback period pdf

Project Initiation, Planning And Execution

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An introduction to project selection

and capital budgeting • In last week’s lesson we began our look at some of that

factors that help us determine how to minimise project

risk by helping us make effective project selection

choices. We first introduced students to methods of risk

analysis before looking at resource constraints and the

concept of the Time Value of Money.

• This week we extend our consideration of how to assess

project viability using quantitative tools by using Payback

Period, Net Present Value (NPV), and the Internal Rate

of Return (IRR).

• This week it is a good idea for students to bring in

their laptops to class as we will be learning how to

use Excel.

Learning objectives

• Demonstrate an understanding of quantitative

factors that assist project selection and

determining viability

• Describe and calculate the payback period for a

project

• Describe, discuss, and calculate Net Present

Value for a project

• Describe, discuss, and calculate the Internal Rate

of Return for a project

Workshop activity

An introduction to project financing

and selection

What quantitative information about a project

would you want to know before deciding

whether to undertake it?

The concept of capital budgeting and project

evaluation

Capital budgeting can be defined as:

“The process by which a business

determines and evaluates

potential large expenses or

investments. These expenditures

and investments might include

projects such as building a new

factory, buying new equipment or

machinery, or investing in a long-

term venture.”

One of the most important functions that financial or project analysts

must learn is how to value different investments or projects. This

function, and the quantitative measures we will explore this week, fall

within the sphere of what is known as capital budgeting.

Three types of quantitative

measures In last week’s lesson we introduced students to the concept of qualitative

and quantitative measures as a means of risk assessment and

determining project viability. While there are many different kinds of

quantitative measures, this week we will focus specifically on three key

measures in order to help determine project viability and chose between

projects.

1. Payback Period

Defined as the length of time required to pay back an initial

investment

2. Net Present Value (NPV)

Defined as the difference between the present value of cash inflows

and the present value of cash outflows over a period of time

3. Internal Rate of Return (IRR)

Defined simply as the a metric used to estimate the profitability of

potential investments.

1. The payback period

At its most basic the payback period can be

defined as the length of time required to pay

back the initial investment in a project.

PBP is the period of time required for

the cumulative expected cash flows

from an investment project to equal

the initial cash outflow.

0 1 2 3 4 5

CF0 CF1 CF2 CF3 CF4 CF5

The payback period

The payback period

Imagine, for instance, the Pear Computing Group wants to initiate a

new project. Management knows the new project will last exactly five

years and allocate $100,000 as startup funding. They also estimate

that it will have cash inflows as indicated below:

Initial investment Year 1 Year 2 Year 3 Year 4 Year 5

$100,000 $10,000 $20,000 $20,000 $50,000 $20,000

Based on the figures above, therefore, the project will repay its initial

$100,000 investment at the end of Year 4. But what if the cash inflow

in Year 4 was actually $60,000?

• It is one of the most widely used tools for

evaluating capital projects

• To calculate the payback period, we need to

know the project’s cost and estimate its future

net cash flows

Decision rule: Accept a project if its payback

period is below some pre-specified threshold

yeartheduringflowCash

erretotmaining eryretbeforeYearsPB

covcosRe covcos 

Formula

PB = 3 + 3 / 10

= 3.3 years

Cumulative

Inflows

Example

yeartheduringflowCash

erretotmaining eryretbeforeYearsPB

covcosRe covcos 

Yes! The firm will receive back the initial

cash outlay in less than 3.5 years.

[3.3 years < 3.5 year max]

• The management of Basket Wonders

has set a maximum PB of 3.5 years

for projects of this type.

• Should this project be accepted?

Payback period based

decision

1- 13

14

Payback Period: Workshop Activity 1

$7,000

1

$7,500

2

($18,000)

Now

$8,000

3

$8,500

4

Cumulative DCF ($11,000) ($3,500) 4,500 13,0000

A project requires an initial investment of $18,000. It is

expected to generate the following cash flows: $7,000, $7,500,

$8,000, and $8,500 at the end of year 1, 2, 3, and 4

respectively. What is this project’s payback period?

Discounted payback = 2 years + (3500 / 8000) = 2.44 years

1. Why do some projects have two payback periods?

2. Which project has the shortest single payback period? Do

you think this is the best project to undertake? Why or why

not?

Payback Period: Workshop Activity 2 Payback Period with Various Cash Flow Patterns

Consider the information below and answer the questions:

Assume a company invests $1 million in Project A that is expected to

generate incremental cash flows for the company of $250,000 each

year for the next 10 years ($2.5 million in total). Consider another

project (Project B) that costs $200,000, will make an incremental

$100,000 each year for the next 3 years.

1) What is the payback period for Project A and B?

2) Which project would you chose based on the payback period?

3) Do you think the payback period has encouraged you to make the

best choice? Why or why not?

Payback Period: Workshop Activity 3

Advantages and disadvantages associated

with using the payback period as a measure As many of you might have noticed by now, perhaps the greatest drawback with

using the payback period as a means of assessing project viability is that it

ignores the Time Value of Money. As we have seen previously, future payments

or values are not the same as those incurred or earned today.

Specific advantages and disadvantages associated with using the payback

period include:

Advantages Disadvantages

Payback period is very simple to calculate. Payback period does not take into account the Time Value

of Money which is a serious drawback since it can lead to

wrong decisions. A variation of payback method that

attempts to remove this drawback is called discounted

payback method.

It can be a measure of risk inherent in a project. Since cash

flows that occur later in a project's life are considered more

uncertain, payback period provides an indication of how

certain the project cash inflows are.

It does not take into account the cash flows that occur after

the payback period.

For companies facing liquidity problems, it provides a good

ranking of projects that would return money early.

Source: https://accountingexplained.com/managerial/capital-budgeting/payback-

period

2. Net Present Value (NPV) The basic concept

• The present value of a project is the difference between the

present value of the expected future cash flows and the initial

cost of the project

NPV = PV(Project’s future cash flows) – PV(Cost of the project)

• Accepting a positive NPV project leads to an increase in

shareholder wealth, while accepting a negative NPV project

leads to a decline in shareholder wealth

• Projects that have a NPV equal to zero implies that management

will be indifferent between accepting and rejecting the project

NPV = −CFo+ σ𝑡 𝑇 𝐶𝐹𝑡

(1+𝑖)𝑡

91.16$ )15.1(

110

)15.1(

80

)15.1(

80

)15.1(

80

15.1

80 300

5432 

 

 

 

 

 NPV

Sample worksheet for Net Present Value analysis

Decision: Due to the negative NPV, reject the project.

If it is accepted, the project will destroy shareholders’ wealth.

t

t

k

NCF

k

NCF

k

NCF NCFNPV

)1( ...

)1(1

1 2

2 0

 

 

 

NPV = 2,423.84 20

Example:

$20,000

1

$14,000

2

($35,000)

Now  ni

FV PV

 

1

Given: Initial Outlay = ($35,000)

CF1 = $20,000; CF2 = $14,000; CF3 = $11,000

Discount rate = 11% p.a.

$11,000

3

PV = $20,000 = $18,018.02

(1+0.11)

PV = $14,000 =

$11,362.71

(1+0.11)2PV = $11,000 = $8,043.11

(1+0.11)3

PV = -$35,000

ACCEPT the project

as its NPV is

positive

Workshop activity

See under “Supplementary Resources”

(Below Week 12)

“MBA643 Week 4 Lecture Examples”

Please attempt to fill in the blanks

Solutions will be available end of Week 4

22

A B

2 Year Cash Flow

3 0 -$35,000

4 1 $20,000

5 2 $14,000

6 3 $11,000

7 11%

8 NPV 2,423.84

Formula used =NPV(B7,B4:B6)+B3

Exercise 1: NPV Using spreadsheet MBA643 Week 4 Lecture Examples

How do we use the NPV formula in Excel?

Workshop Activity:

Consider, the following example of a project's cash flows. Assume the appropriate

discount rate is 12%.

Yr 0

($20,000)

Yr 1

$6,000

Yr 2

$7,000

Yr 3

$7,000

Yr 4

$6,000

What is the NPV for this project ?

PV1 =

PV2 =

PV3 =

PV4 =

Aggregate PV =

NPV =

Based on the _______ NPV you would ______the project

Workshop Activity:

Consider, the following example:

Yr 0

($20,000)

Yr 1

$6,000

Yr 2

$7,000

Yr 3

$7,000

Yr 4

$6,000

What is the NPV for this project ?

PV1 = 6000 / (1.12) = $5,357

PV2 = 7000 /(1.12)2 = $5,580

PV3 = 7000/(1.12)3 = $4,982

PV4 = 6000 /(1.12)4 = $3,813

Aggregate PV = $19,732

NPV = $19,732 – ($20,000)

= - $268

Based on the negative NPV you would reject the project

25

Excel Exercise 2: Workshop Activity

Imagine for the above project that the analyst has changed his

mind about what the cash flows and discount rate should be.

Using the Excel spreadsheet from (in Excel Exercise 2a and 2b)

demonstrate how the NPV and the decision would change if:

a) The cash flows in years 2 and 3 changed to $11,000 received at

end of year 2 and $10,000 received at end of year 3; or

b) The discount rate is 20% not 11%. How does a higher discount rate

affect the present value of future cash flows?

26

A B

2 Year Cash Flow

3 0 -$35,000

4 1 $20,000

5 2 Changed CF

6 3 Changed CF

7 11%

8 NPV ???

Formula used =NPV(B7,B4:B6)+B3

Exercise 2a: NPV Changing Cash Flows MBA643 Week 4 Lecture Examples

See Excel Lecture Example File

27

A B

2 Year Cash Flow

3 0 -$35,000

4 1 $20,000

5 2 $14,000

6 3 $11,000

7 Change Discount rate

8 NPV ??

Formula used =NPV(B7,B4:B6)+B3

Exercise 2b: NPV Changing Discount Rate MBA643 Week 4 Lecture Examples

See Excel Lecture Example File

Advantages and disadvantages associated

with Net Present Value

Specific advantages and disadvantages associated with using Net Present Value

include:

Advantages Disadvantages

NPV recognises the concept of the Time Value of Money. In

each period cash flows are discounted by another period of

capital cost.

The biggest disadvantage is that assumptions about a

company’s capital costs, as indicated by the discount rate,

require a degree of guesswork.

NPV indicates to investors and analysts whether a project will

make money for investors.

Making assumptions about capital that are too low may result

in making suboptimal investments.

NPV takes into consideration the cost of capital and offers an

indication of the level of risk associated with a project.

Making assumptions about capital that are too high may

mean forgoing other good (better) investments/projects.

NPV also requires you to make assumptions abut projected

cashflows. These may also not be accurate and can

influence decision making in a positive or negative way.

NPV will only indicate whether a project meets the required

rate of return as expressed via the discount rate. It will not

indicate the actual rate of return.

3. Internal Rate of Return The Internal Rate of Return is the most sophisticated of our three quantitative

measures which analysts use to determine the profitability of investments and

projects. The IRR is the discount rate where the present value of the cash

inflows exactly equals the initial investment. In other words, it is the discount

rate required in order to produce a NPV of zero.

To determine the IRR we use the same formula used above for NPV.

To calculate the IRR, however, requires either a trial-and-error approach or

the use of specific software such as MS Excel.

Generally, the higher the IRR the more attractive the project is to undertake.

And because it offers a uniform result it is suitable to use to assess projects of

different types. Assuming the costs of investment are equal, the project with

the highest IRR would be the one to undertake.

Internal Rate of Return The ‘hurdle rate’

The IRR tells analysts and investors what kind of return they

can expect. It can be defined as the percentage rate of

return for each dollar investment over each investment

period. It is a key tool used to assist decision making.

When investing, however, many companies also use what is

known as a ‘hurdle rate’. Simply put, the hurdle rate is the

rate of return that a company requires in order to consider a

project worth pursuing. If a company has a hurdle rate of

10%, for example, anything above this will be attractive and

would lead them to accept a project proposal.

31

Example: IRR Given: Initial Outlay = ($560)

CF1 = $240; CF2 = $240; CF3 = $240

Required return = 12% p.a.

$0 = - $560

+ $240 / (1 + IRR)

+ $240 / (1 + IRR)2

+ $240 / (1 + IRR)3

Trial and Error

IRR =?

You will not

have to

calculate the

IRR

32

A B

2 Year Cash Flow

3 0 -$560

4 1 $240

5 2 $240

6 3 $240

7 12%

8 IRR 13.70%

Formula used =IRR(B3:B6)

Exercise 3: IRR MBA643 Week 4 Lecture Examples

Advantages and disadvantages associated

with Internal Rate of Return

Specific advantages and disadvantages associated with using Internal Rate of

Return include:

Advantages Disadvantages

Like NPV, the IRR recognises the Time Value of Money. Perhaps the biggest drawback of IRR is that it ignores the

dollar value in favour of a percentage. For instance, a 15%

return on $1,000,000 (i.e. $150,000) would always be more

favourable to a 50% return on $10,000 (i.e. $5,000).

While a sophisticated concept, it is actually easy to calculate

using MS Excel.

The IRR only includes consideration of capital costs at the

expense of any additional (non-capital) future costs.

The IRR shows the return on the original amount invested. The IRR makes the implicit assumption that cash flows are

reinvested at the IRR rate, which may not always be the

case.

It gives consideration to the objective of maximising investor

wealth.

IRR can sometimes offer conflicting advice to NPV

depending on the size and nature of specific types of

projects.

One final measure: The Return on

Investment (ROI) One final measure that you might have heard of and which we should mention is the so-

called Return on Investment (ROI).

It is the most simple and crude measure, but does give a basic indication of the relative

performance of different investments or projects, at least in the short term. The ROI is a

simple percentage figure derived by dividing a realised profit by your original investment.

So, if I invested $1,000 in a business and sold it for $1200 a year later I would have made

a $200 profit, or a 20% return on investment (ROI).

ROI = Profit / Investment x 100

The ROI is useful as it offers a quick and simple way to compare the performance of

different investments.

The biggest drawback, however, is that it does not allow for consideration of the impact of

time. If, for example, my $200 profit from the sale of my business did not come after one

year, but five, my 20 percent profit would not be 20 percent per annum, but rather four

per cent per annum.

Comparing Payback Period, NPV, and

IRR Each of the measures discussed this week have their own advantages and disadvantages

and for this reason it is important to develop a good understanding of their use: what they

are good at doing and what they are not so good at doing.

NPV and IRR, for example, in most instances they will accord with one another. But there

are times when they differ by accepting or rejecting the same decisions or proposals.

NPV tends to be the more conservative approach.

Add to this that different companies will have different expectations. Some will require

quick payback periods with very high rates of return (IRR), while others might seek lower

risks, accept lower returns and expect longer payback periods.

Capital budgeting in

practice

“We use a sample survey to analyse the capital-budgeting

practices of Australian listed companies. We find that NPV, IRR

and Payback are the most popular evaluation techniques.

Discounting is typically by the weighted average cost of capital

[Topic 10], assumed constant for the life of the project, and with the

same discount rate across divisions. Projects are usually

evaluated using NPV, but the company is likely to also use other

techniques such as IRR and payback methods. The project cash

flow projections are made from three to ten years into the future…”

Paper: Truong, G., Partington, G. and Peat, M. (2008), “Cost-of-capital estimation and capital-budgeting practice in Australia”, Australian Journal of

Management, Vol. 33 No. 1, pp. 95-122. (Available on portal)

Workshop Activity • In groups try and set up an Excel spreadsheet to address

the following question. You can use the spreadsheet set

up in Week 4 Lecture Examples- Exercise 4.

Champlain Ltd. is investigating two computer systems. The Alpha 8300

costs $3,122,300 and will generate annual cost savings of $1,345,500

over the next 5 years. The Beta 2100 system costs $3,750,000 and will

produce cost savings of $1,125,000 in the first 3 years and then $3.5

million for the next two years.

1) If the company’s discount rate for similar projects is 14 percent,

what is the NPV for the two systems?

2) Which one should be chosen based on the NPV?

3) Which project would you select based on the IRR?

4) Which project would you select based on Payback period?

5) Do any of the methods disagree on which project to pick? Why?

38

Exercise 4: NPV Comparing Two Projects MBA643 Week 4 Lecture Examples

Next Week

Now that we understand something of how financial

risk is determined, we might start to consider some

of the different types of risk.

In next week’s lesson we will examine key functions

such as:

• Risk planning

• Risk assessment

• Risk types and identification, and

• Risk handling and responses