1.

Payback time: Calculate the payback time

for the two cash flows given below and discuss the
differences in your results. (Arrows not to scale)

40 k$ 40 k$ 40 k$
30 k$
(a) 20 k$ (a) This is the cash flow used
in several lecture examples.

-91 k$ 1000 k$ 2000 k$

40 k$ 40 k$
20 k$
(b)

-91 k$
 100000

1. Payback time:

Cumulative cash flow ($)

50000

Solution 0 Series1
0 1 2 3 4 5 6

-50000

-100000
40 k$ 40 k$ 40 k$
Time period (yr)
30 k$
(a) 20 k$
Payback time = ~2.7 years
DCFRR = 23.6 %

-91 k$ 1000 k$ 2000 k$

40 k$ 40 k$
20 k$ Payback time = ~2.7 years
(b) DCFRR = 127 %

-91 k$
 1. Payback time: Solution

Payback time = ~2.7 years Payback time considers only the cash flows
(a) up to when the cumulative cash flow first
reaches zero.
DCFRR = 23.6 %
The profitability of a project depends on the
time value of money and all cash flows.
In this example, very large cash flows occur
in (b) after the payback time.
Therefore, (b) is much more financially
Payback time = ~2.7 years attractive.
(b) The payback time analysis gives a faulty
DCFRR = 127 % evaluation of these projects.
This example demonstrates a serious
weakness in the payback method.
 2. Return on original Investment (ROI):
Calculate the ROI for the two cash flows given below
and discuss the differences in your results. (Arrows not
to scale. No working capital.)
500 k$ per year

(a) 250 k$ per year

-2 M$ 3.75 M$

(b)

-2 M$
 2. Return on original Investment (ROI):
Solution

ROI = (average annual profit)/(fixed capital+working capital)

With a MARR = 12%

375000
(a) ROI   0.188 or 18.8% NPV(a) = 0.31 M$
2000000

375000
(b) ROI   0.188 or 18.8% NPV(b) = -0.80 M$
2000000
 2. Return on original Investment (ROI):
Solution

ROI = (average annual profit)/(fixed capital+working capital)

The ROI does not consider the time value of money. Therefore, the two projects
are found to be equivalent using ROI because they have the same average profit
over the life of the project.
However, Project (a) has positive cash flows earlier in the project, and
therefore, it is more financially attractive, as confirmed by their NPV’s.
This example demonstrates a serious weakness in the ROI method.
 3. Net Present Value (NPV) for pump:
Calculate the before-tax NPV for a pump using the
following data.

Initial installed cost = $2500 Salvage value = $200

Annual operating cost = $900 Pump life = 5 years

MARR = 10% Project life = 5 years

http://www.pumpmachinery.co.nz/brands_grundfos
 3. Net Present Value (NPV) for pump:
Solution.

year 0 1 2 3 4 5

capital -2500 0 0 0 0 0

Operat. 0 -900 -900 -900 -900 -900

cost
Salvage 0 0 0 0 0 200

Cash -2500 -900 -900 -900 -900 -700

flow
Discount 1 .91 .83 .75 .68 .62
factor
Present -2500 -819 -747 -675 -612 -434
value
NPV = Sum (present values) = $ -5787
 4. Annualized measure of profit:
In some circumstances, people like to express the net
effect of all economic factors in an annualized manner.
This must account for the time value of money. Develop
an annualized equivalent to NPV.
• What (equal) annual cash flow is equivalent to the NPV value
at an interest rate of i?
• What is the criterion for an attractive investment?

NPV

EAV = equivalent annual value (worth)

    
 4. Annualized measure of profit:
Solution.

Write the expression equating the NPV and EAV. We will use “A” for EAV
and “P” for NPV, as is done in many interest tables.

This expression can be simplified to the following.

Factor = (P/A, i, n)

These factors are available in the interest tables in books or in Excel

functions.
 4. Annualized measure of profit:
Solution.

As an example, what is the equivalent NPV for cash flows of $1000

in years 1 to 9 when the MARR = 15%?

The answer is not 1000 * 9 = 9000 because of the time value of

money.

P = 1000 (P/A, 0.15, 9) = 1000 * 4.7716 = $ 4772

For an attractive investment, the EAV must be positive

when using the MARR for the compound interest rate.
 5. Comparing Alternatives, repeated
projects: In some instances, a project has an
essentially infinite life. Alternatives often can be
repeated without extra cost.

Problem: A process needs a pump, and the need will exist for a
very long time. There are two alternative pumps available. Each
requires the same energy for operation, can be installed on January
1 and operated immediately; time to place the order, deliver and
install it is ~ 1 year. Pump only operates in period n=1 and
onwards. MARR = 15%. Determine the lowest cost alternative.

Pump A Pump B
Installed cost $ 9500 $ 22000
Salvage value $ 0 $ 0
Life 2 years 5 years
 5. Comparing Alternatives, repeated
projects: Solution I.
We can compare alternatives using NPV, DCFRR, and so forth when
the project lives are the same. Since this project has essentially
infinite life, we can use any period in which the projects have the
same life. We use the “least common multiple method”.
Same
Project has infinite life Least common multiple method project
Equivalent Annual value (worth) method
lives
Pump A -9500

year 0 1 2 3 4 5 6 7 8 9 10

CF 0 -9500 0 -9500 0 -9500 0 -9500 0 -9500 0

PV 0 -8260.87 0 -6246.4 0 -4723.18 0 -3571.4 0 -2700.49 0
NPV -25502.34755

Better choice

Pump B -22000

year 0 1 2 3 4 5 6 7 8 9 10
CF 0 -22000 0 0 0 0 -22000 0 0 0 0
PV 0 -19130.4 0 0 0 0 -9511.21 0 0 0 0
NPV -28641.64189
 5. Comparing Alternatives, repeated
projects: Solution II.
The projects can be repeated without cost. Therefore, we could also
compare the annualized cost for each alternative for one “cycle”. We
use the “equivalent annual worth”.

Pump A This is a two-year project, with 9500 invested in year one

Invest -9500
NPV -8260.87
EAV factor 0.615116 (A/P, .15, 2)
EAV -5081.4
Better choice
Pump B This is a five-year project with 22000 invested in year one

Invest -22000
NPV -19130.4
EAV factor 0.298316 (A/P, .15, 5)
EAV -5706.91
 6. Comparing Alternatives, with fixed
project life: In some instances, a project has fixed
life. Alternative plans must satisfy the total life.

Problem: A process needs a pump, and the need will exist for
six years. There are two alternative pumps available. Each
requires the same energy for operation. MARR = 15%.
Determine the lowest cost alternative.

Pump A Pump B
Installed cost $ 9500 $ 22000
Salvage value $ 0 $ 0
Life 2 years 6 years
 6. Comparing Alternatives, with fixed
project life: Solution

Pump A -9500

year 0 1 2 3 4 5 Requires three

pump purchases.
CF -9500 0 -9500 0 -9500 0
PV -9500 0 -7183.36 0 -5431.66 0
NPV -22115

Pump B -22000

year 0 1 2 3 4 5
CF -22000 0 0 0 0 0 Requires one pump
PV -22000 0 0 0 0 0 purchase
NPV -22000

Better choice
9. After-tax profitability:
Answer question 8-10 from Peters, Timmerhaus and West.
 13. NPV measure of profitability

The following cash flow is given for two projects.

Determine the NPV for each and discuss the results.
Profitability of two projects

MARR = 0.12
Project 1
year
0 1 2 3 4 5
cash flow -4000 1300 1300 1300 1300 1300
PV -4000 1160.714 1036.352 925.3143 826.1735 737.6549
NPV 686.2091
DCFRR 18.72%

Project 2
year
0 1 2 3 4 5
cash flow -4000000 1109829 1109829 1109829 1109829 1109829
PV -4000000 990919 884749.1 789954.6 705316.6 629746.9
NPV 686.2
 13. NPV measure of profitability

Profitability of two projects

MARR = 0.12
Project 1
year
0 1 2 3 4 5
cash flow -4000 1300 1300 1300 1300 1300
PV -4000 1160.714 1036.352 925.3143 826.1735 737.6549
NPV 686.2091
DCFRR 18.72%

Project 2
year
0 1 2 3 4 5
cash flow -4000000 1109829 1109829 1109829 1109829 1109829
PV -4000000 990919 884749.1 789954.6 705316.6 629746.9
NPV 686.2
DCFRR 12.01%
 13. NPV measure of profitability

The following cash flow is given for two projects.

Determine the NPV for each and discuss the results.

We note that the NPV values are the same for both projects.
However, Project 2 involves an investment of one thousand times
the investment for Project 1. We also note that the DCFRR for
Project 1 is higher than Project 2.

We have seen a number of advantages for NPV (simpler

calculations for exclusive alternatives, no controversy regarding
reinvestment assumption), while this example displays a
shortcoming for the NPV profitability measure.

Conclusion: Use NPV and DCFRR and observe the cash flows.
 14. Effect of uncertainty

Let’s calculate the before-tax profitability

(NPV) for the following cash flows. Also, let’s
evaluate the sensitivity to  20% uncertainty in
the initial investment in year 0 and the cash
flows in years 1-5.

interest (MARR) = 12 %

Calculate the profitability

year 0 1 2 3 4 5

cash flow -4000000 1109829 1109829 1109829 1109829 1109829

14. Effect of uncertainty
The base case solution is given in the
following table. Often, students report
that the profitability = 685  685*.20.

Is this correct?
uncertainty (%)

investment = -4000000 0 (range 0-20%)

Annual cash flow = 1109829 0 (range 0-20%)
interest (MARR) = 12 %

Calculate the profitability

year 0 1 2 3 4 5

cash flow -4000000 1109829 1109829 1109829 1109829 1109829

PV -4000000 990918.8 884748.9 789954.3607 705316.4 629746.8

NPV = 685.1679
DCF = 12.01%
 14. Effect of uncertainty
The proposed answer is not correct!

The proper method depends upon the correlation among

the uncertainties in the various sources of uncertainty.
Here, we will consider them independent. Thus, we set the
uncertainties to their extreme magnitudes with different
signs.

The result is shown in the figure on the following

slide, showing values that differ from the base case by over
a factor of 1000!

Lesson: When calculating the difference between large

numbers, even small changes in the numbers can have a
large affect on the result.
 14. Effect of uncertainty

2000000

1500000

1000000
Net Present vale ($)

500000

0
-25 -20 -15 -10 -5 0 5 10 15 20 25

-500000

-1000000

-1500000

-2000000

Uncertainty in cash flows (%), Opposite signs for investment

and revenues; sign is for investment in plot