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Contemporary Engineering Economics, 4 th edition, © 2007 Initial Project Screening Method - Payback Period Lecture No.15 Chapter 5 Contemporary Engineering Economics Copyright © 2006
Contemporary Engineering Economics, 4 th edition, © 2007 Chapter Opening Story
Contemporary Engineering Economics, 4 th 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, 4 th edition, © 2007 Bank Loan vs. Investment Project
Contemporary Engineering Economics, 4 th 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, 4 th edition, © , , , , , Years (n) 3.2 years Payback period $85,000 $15,000 $25,000 $35,000 $45,000 $35, Years Annual cash flow Cumulative cash flow ($)
Contemporary Engineering Economics, 4 th 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, 4 th edition, © 2007 Discounted Payback Period Calculation PeriodCash FlowCost of Funds (15%)* Cumulative Cash Flow 0-$85, ,000-$85,000(0.15) = -$12,750-82, ,000-$82,750(0.15) = -12,413-70, ,000-$70,163(0.15) = -10,524-45, ,000-$45,687(0.15) =-6,853-7, ,000-$7,540(0.15) = -1,13136, ,000$36,329(0.15) = 5,44976,778 * Cost of funds = (Unrecovered beginning balance) X (interest rate)
Contemporary Engineering Economics, 4 th edition, © 2007 Illustration of Discounted Payback Period
Contemporary Engineering Economics, 4 th edition, © 2007 Summary Payback periods can be used as a screening tool for liquidity, but we need a measure of investment worth for profitability.
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