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Engg Econ Lecture 3.7 - Payback Period

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5 views16 pages

Engg Econ Lecture 3.7 - Payback Period

Uploaded by

Karl Cristian Daquil
Copyright
© © All Rights Reserved
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Engineering Economics

Lesson 3
Basic Economy Study Methods
Sullivan, et al. (2015). Engineering Economy, 16th ed., Chapter 5 (pp. 186-239)
Contents
1. The Minimum Attractive Rate of Return
2. The Present Worth Method
3. The Future Worth Method
4. The Annual Worth Method
5. The Internal Rate of Return Method
6. The External Rate of Return Method
7. The Payback Period Method
8. The Benefit/Cost Ratio Method
Engineering Economics
Lecture 3.4
The Payback (Payout) Method
Sullivan, et al. (2015). Engineering Economy, 16th ed., pp. 215-218
Introduction
• All methods presented thus far reflect the profitability of a proposed
alternative for a study period of 𝑁.
• The payback method, a.k.a. the simple payout method, mainly
indicates a project’s liquidity rather than its profitability.
• Historically, the payback method has been used as a measure of a
project’s riskiness, since liquidity deals with how fast an investment
can be recovered.
• A low valued payback period is considered desirable.
• Quite simply, the payback method calculates the number of years
required for cash inflows to just equal cash outflows.
The Simple Payback Period Equation
• Hence, the simple payback period is the smallest value of 𝜃(𝜃 ≤ 𝑁)
for which this relationship is satisfied under our normal EOY cash-flow
convention.
• For a project where all capital investment occurs at time 0, [Eqn. 5-9]:
𝜃

෍ 𝑅𝑘 − 𝐸𝑘 − 𝐼 ≥ 0
𝑘=1
• Where: 𝑅𝑘 = excess of receipts over expenses in period 𝑘;
𝐸𝑘 = excess of expenditures over receipts in period 𝑘;
𝐼 = initial investment for the project.
Simple Payback Period, 𝜃
• The simple payback period, 𝜽, ignores the time value of money and
all cash flows that occur after 𝜽.
• If this method is applied to the investment project in Example 5-13,
the number of years required for the undiscounted sum of cash
inflows to exceed the initial investment is four years.
• This calculation is shown in Column 3 of Table 5-2.
• Only when 𝜽 = 𝑵 (the last time period in the planning horizon) is the
market (salvage) value included in the determination of a payback
period.
Simple Payback Period, 𝜃
• As can be seen from Equation (5-9), the payback period does not
indicate anything about project desirability except the speed with
which the investment will be recovered.
• The payback period can produce misleading results, and it is
recommended as supplemental information only in conjunction with
one or more of the five methods previously discussed.
Discounted Payback Period, 𝜃′
• Sometimes, the discounted payback period, 𝜽′(𝜽′ ≤ 𝑵), is calculated
so that the time value
′
of money is considered [Eqn. 5-10]:
𝜃

෍ 𝑅𝑘 − 𝐸𝑘 (𝑃/𝐹, 𝑖%, 𝑘) − 𝐼 ≥ 0
𝑘=1
• Where: 𝑅𝑘 = excess of receipts over expenses in period 𝑘;
𝐸𝑘 = excess of expenditures over receipts in period 𝑘;
𝐼 = capital investment, usually made at present time (𝑘 = 0);
𝑖% = MARR;
𝜃 ′ = the smallest value that satisfies Equation (5-10).
𝑖 = effective interest rate per interest period; 𝑁 = number of interest periods; 𝐴 = uniform series amount (occurs at the end of each interest period); 𝐹 = future equivalent; 𝑃 = present equivalent
Discounted Payback Period, 𝜃′
• Table 5-2 (Columns 4 and 5) also illustrates the determination of 𝜽′
for Example 5-13.
• Notice that 𝜽′ is the first year in which the cumulative discounted
cash inflows exceed the $25,000 capital investment.
• Payback periods of three years or less are often desired in U.S.
industry, so the project in Example 5-13 could be rejected, even
though it is profitable.
• [IRR = 21.58%, PW(20%) = $934.29.]
• Fig. 5-9 shows the simple and discounted payback periods.
Simple vs. Discounted Payback Periods
• This variation (𝜃′) of the simple payback period produces the
breakeven life of a project, in view of the time value of money.
• However, neither payback period calculation includes cash flows
occurring after 𝜃 (or 𝜃′).
• This means that 𝜃 (or 𝜃′) may not take into consideration the entire
useful life of physical assets.
• Thus, these methods will be misleading if one alternative has a longer
(less desirable) payback period than another but produces a higher
rate of return (or 𝑃𝑊) on the invested capital.
Conclusion
• Using the payback period to make investment decisions should
generally be avoided except as a secondary measure of how quickly
invested capital will be recovered, which is an indicator of project risk.
• The simple payback and discounted payback period methods tell us
how long it takes cash inflows from a project to accumulate to equal
(or exceed) the project’s cash outflows.
• The longer it takes to recover invested monies, the greater is the
perceived riskiness of a project.
end

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