Initial Project

Screening Method -
Payback Period
Lecture No.15
Chapter 5
Contemporary Engineering Economics
Copyright © 2006

Contemporary Engineering
Economics, 4th edition, © 2007
Chapter Opening Story

Contemporary Engineering
Economics, 4th edition, © 2007
Ultimate Questions
 Municipalities’ Point of View:
 Would there be enough new revenues from installing the
expensive parking monitoring devices?
 How many devices could be installed to maximize the
revenue streams?
 Manufacturer's Point of View:
 Would there be enough demand for their product to justify
the investment required in new facilities and marking?
 What would be the potential financial risk if the actual
demand is far less than its forecast or adoption of
technology is too slow?

Contemporary Engineering
Economics, 4th edition, © 2007
Bank Loan vs. Investment
Project

Contemporary Engineering
Economics, 4th edition, © 2007
Example 5.1 Describing
Project Cash Flows
Year Cash Inflows Cash Net
(n) (Benefits) Outflows Cash Flows
(Costs)
0 0 $650,000 -$650,000

1 215,500 53,000 162,500

2 215,500 53,000 162,500

… … … …

8 215,500 53,000 162,500

Contemporary Engineering
Economics, 4th edition, © 2007
Cash Flow Diagram for the
Computer Process Control
Project

Contemporary Engineering
Economics, 4th edition, © 2007
Payback Period
 Principle:
How fast can I recover my initial investment?
 Method:
Based on the cumulative cash flow (or
accounting profit)
 Screening Guideline:
If the payback period is less than or equal to
some specified payback period, the project
would be considered for further analysis.
 Weakness:
Does not consider the time value of money
Contemporary Engineering
Economics, 4th edition, © 2007
Example 5.3 Payback
Period
N Cash Flow Cum. Flow

0 -$105,000+$20,000 -$85,000
1 $35,000 -$50,000
2 $45,000 -$5,000
3 $50,000 $45,000
4 $50,000 $95,000
5 $45,000 $140,000
6 $35,000 $175,000

Payback period should occurs somewhere

between N = 2 and N = 3.
Contemporary Engineering
Economics, 4th edition, © 2007
 $45,000 $45,000
$35,000 $35,000
Annual cash flow $25,000
$15,000
0
1 2 3 4 5 6
Years

$85,000

150,000
Cumulative cash flow ($)

100,000 3.2 years

Payback period
50,000

0
-50,000

-100,000

0 1 2 3 4 5 6
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Years (n)
Economics, 4th edition, © 2007
Practice Problem
 How long does it take to recover the initial
investment for the computer process control
system project in Example 5.1?

Initial Cost
Payback Period =
Uniform annual benefit
$650,000

$162,500
4 years
Contemporary Engineering
Economics, 4th edition, © 2007
Discounted Payback
Period
 Principle:
How fast can I recover my initial investment
plus interest?
 Method:
Based on the cumulative discounted cash flow
 Screening Guideline:
If the discounted payback period (DPP) is less
than or equal to some specified payback period,
the project would be considered for further
analysis.
 Weakness:
Cash flows occurring after DPP are ignored
Contemporary Engineering
Economics, 4th edition, © 2007
 Discounted Payback Period
Calculation
Period Cash Flow Cost of Funds Cumulative
(15%)* Cash Flow
0 -$85,000 0 -$85,000

1 15,000 -$85,000(0.15) = -$12,750 -82,750

2 25,000 -$82,750(0.15) = -12,413 -70,163

3 35,000 -$70,163(0.15) = -10,524 -45,687

4 45,000 -$45,687(0.15) =-6,853 -7,540

5 45,000 -$7,540(0.15) = -1,131 36,329

6 35,000 $36,329(0.15) = 5,449 76,778

* Cost of funds = (Unrecovered beginning balance) X (interest rate)

Contemporary Engineering
Economics, 4th edition, © 2007
Illustration of Discounted
Payback Period

Contemporary Engineering
Economics, 4th edition, © 2007
Summary

Payback periods can be used as a screening

tool for liquidity, but we need a measure of
investment worth for profitability.

Contemporary Engineering
Economics, 4th edition, © 2007