SERIES

INTRODUCTION
Fundamental to many financial calculations is the process of allocating or paying out or receiving
money at regular intervals. Typical examples include: depreciation calculations, investing funds, loan
repayment, cash flow analysis. These can be represented by series of which the most common types
are arithmetic and geometric progressions.
ARITHMETIC SEQUENCES

• An arithmetic sequence is a series of quantities where each new value

is obtained by adding a constant amount to the previous value. The
constant amount is sometimes called the common difference.

• An arithmetic sequence is of the form ; a, a + d, a + 2d, … , a + (n-1)d

• Where a is the first value, d is the common difference and n is the

number of terms in a sequence.
Example 1
A firm rents its premises and the rental agreement provides for a
regular annual increase of K26, 500. If the rent in the first year is
K85,000, what is the rent in the tenth year?
Solution:

• Here a = K85,000 n = 10, d = K26,500

Example 2

A firm buys a power press for K325,000 which is expected to last for 20
years and to have a scrap value of K75,000. If the depreciation is on the
straight line method, how much should be provided for in each year.
Solution:

• In such a problem the number of terms in the series is 1 more than the number of
years because the cost is the value at the beginning of the first year and the scrap
value is at the end of the final year.

• Straight line depreciation is K12,500 per annum.

SUM OF ARITHMETIC PROGRESSION

• One way to find the sum of an arithmetic progression is to evaluate

each of the successive terms and add them up. This could be lengthy
if numerous terms are involved, so the following formula can be used.

• Where S = sum of the progression.

Example 3

How much rent in total did the firm in example 1 pay for its premises
over ten years?
Solution:
Example 4

An employee, who received fixed annual increments had a final salary

of K90,000 per annum after 10 years. If his total salary was K650,000
over 10 years, what was his initial salary?
Solution:

• And we know that

• Substituting we obtain
GEOMETRIC SEQUENCES

• A series of quantities where each value is obtained by multiplying the

previous value by a constant which is called the common ratio.

• A geometric sequence has the form

• Where
Example 5

Given the same details as in example 2 what would be the depreciation

rate as a percentage if the depreciation was to be calculated on the
reducing balance method?
Solution:

• Which may be solved using logarithms (refer to solving logarithmic equations) or scientific calculator.

•
Example 6

A building cost K5,000,000 and it is decided to depreciate it at 10% per

annum on the reducing balance method. What would be its written
down value be after 25 years?
Solution:

Notes:

1. The common ratio , in depreciation problems is always obtained by deducting the depreciation rate from 1,
i.e if the depreciation rate is 20% then

2. Make sure you can deal with the multiplication and division of negative logarithms
SUM OF GEOMETRIC SEQUENCES

In a similar fashion to an arithmetic sequence, the individual terms

could be evaluated and added together but a simple formula exists:

Where S is the sum of the sequence.

Example 7

A company sets up a sinking fund and invests K10,000 each year for 5
years at 9% compound interest. What will the fund be worth after 5
years?
Solution:

From such a question it can be inferred that the K10,000 is invested at

the end of each year so that the last allocation earns no interest. To
clarify the problem the whole sequence is set out below.

From this it will be seen that the sequence is the reverse of the usual
order and that the number of terms in the sequence n is 5, i.e the same
number of years.
INTEREST
COMPUTATIONS
The aim of this part of the course is to introduce the concept of interest which is fundamental to the study of
finance. Interest is the fee paid (or earned) for use of money over time. Borrowing and lending are opposite sides
of the same transaction, like getting financing and investing. The amount of the fee depends on the amount
borrowed (principal), the annual rate of interest charged and the length of time the money is borrowed. Bank
discount which is sometimes referred to as interest in advance also represents a fee paid for the use of money
overtime.
OBJECTIVES

1. Define “simple interest,” and solve problems involving this concept.

2. Calculate any single variable—principal, interest rate, amount of interest, or time—given the other three.

3. Define “real interest” and use the formula to calculate it given other parameters.

4. Define “nominal interest”

5. Define “effective interest” and calculate the effective interest given the nominal interest

6. Define “compound interest” and use the properties of logarithms and exponential functions to calculate any
of the parameters required given the others.
REAL INTEREST RATE

• This is the rate of interest which takes into account the effect of inflation. The concept of real interest rate is
useful to account for the impact of inflation. In the case of a loan, it is the real interest that a lender
effectively receives. For example, if a lender is receiving 10 percent from a loan, and the inflation rate is
10%, then the real rate of interest is zero: despite the increase in nominal amount of currency received, the
lender would have no monetary benefit from such a loan because each unit of currency would get devaluated
due to inflation by the same factor as the nominal amount gets increased.

• The relationship between the real interest value, the nominal rate , and the inflation , is given by the Fisher
formula as follows
Example

Find the real rate of interest for a loan which pays a nominal rate of
10% and inflation is projected at 8%.
Solution:

• In this analysis, the nominal rate is the stated rate, and the real interest rate is the interest after the expected
losses due to inflation. Since the future inflation can only be estimated, the real interest rate may be different;
the premium paid may be higher or lower. By contrast, the nominal rate is known in advance.
NOMINAL INTEREST RATE

The nominal interest rate (also known as an Annualised Percentage Rate

or APR) is the periodic interest rate multiplied by the number of periods
per year. For example, a nominal annual interest rate of 12% based on
monthly compounding means a 1% interest rate per month
compounded.
EFFECTIVE INTEREST RATE

This is the interest rate that takes into account the effect of
compounding.
EFFECTIVE VS NOMINAL RATE OF INTEREST

• Most interest rates are expressed as per annum figures even when the interest is compounded over periods less than one year.
In such cases the given interest rate is called the nominal rate.

• Depending on whether the compounding is done daily, weekly, monthly, quarterly or half yearly, the effective rate sometimes
referred to as annual percentage rate(APR) will vary by differing amounts from the nominal rate.

• Given the nominal rate of interest, the effective interest can be calculated as follows:

• Where the nominal is rate and is the number of periods of compounding.

• Confusingly, in the context of inflation, 'nominal' has a different meaning. A nominal rate can mean a rate before adjusting for
inflation, and a real rate is a constant-prices rate. The Fisher equation is used to convert between real and nominal rates. To
avoid confusion about the term nominal which has these different meanings, some finance textbooks use the term 'Annualised
Percentage Rate' or APR rather than 'nominal rate' when they are discussing the difference between effective rates and APR's.
Examples
• Monthly compounding

• Example 1: A nominal interest rate of 6% compounded monthly is equivalent to an effective interest rate of 6.17%.

• Example 2: 6% annually is credited as 6%/12 = 0.5% every month. After one year, the initial capital is increased
by the factor (1+0.005)12 ≈ 1.0617.

• Daily compounding

• A loan with daily comp have a substantially higher rate in effective annual terms. For a loan with a 10% nominal
annual rate and daily compounding, the effective annual rate is 10.516%. For a loan of $10,000 (paid at the end of
the year in a single lump sum), the borrower would pay $51.56 more than one who was charged 10% interest,
compounded annually.

• ( Please try these with your calculator and make sure you are comfortable with the answers you get).
Example 3
• A finance company loans money at 20% nominal interest but compounds monthly. What is the effective rate?

• Solution:
SIMPLE INTEREST AND
SIMPLE DISCOUNT
SIMPLE INTEREST AND SIMPLE DISCOUNT

• When an investor lends money to a borrower, the borrower must pay back the
money originally borrowed and also the fee charged for the use of money, called
interest. From the investor’s point of view, interest is the income from the invested
capital. The capital originally invested is called the principal. The sum of the
principal and the interest due is called the amount or accumulated value. Any
interest transaction can be described by the rate of interest, which is the ratio of
the interest earned in one time unit to the principal.

• At simple interest, the interest is computed on the original principal during the
whole time, or term of the loan, at the stated annual rate of interest.
NOTATIONS

• P = principal, or present value of S, or the discounted value of S, or the proceeds

• I= simple interest

• S = amount, or the accumulated value of P, or the maturity value of P

• The simple interest I on principal P for t years at an annual rate r is given by

• And the amount is given by

NOTATIONS
• The factor 1 + rt in equation 2 is called an accumulation factor at simple interest, and the process of calculating S from
P via equation 2 is called accumulation at simple interest.

• From equation 2 we have

• As the present value or discounted value at rate r of S due in t years' time . The factor is called a discount factor at
simple interest, and the process of calculating P from S via equation 3 is called discounting at simple interest.

• The time t must be in years. When the time is given in months, then

• When the time is given in days, we may calculate either exact simple interest, on the basis of 365 -day year( leap year
or not) that is
Example 1
Find the exact simple interest on a 60 day loan of K1500 at 14.5%.
Solution:
Example 2
At what rate of interest will K1200 accumulate interest of K72 in 6
months?
• Solution:
Example 3

• How long will it take for K500 to accumulate to at least K560 at

13.25% ordinary simple interest?

• Solution:
Example 4

• A man borrows K1000 for 220 days at 12.17%. What amount must he
repay?

• Solutions:
Example 5

• Eighty days after borrowing money, a person pays back exactly K850.
How much was borrowed if the K850 payment includes principal and
simple interest at 9.75%?

• Solution:
Example 6
• Find the discounted value of K1000 due in 3 months is the rate is 11%.

• Solution:
SIMPLE DISCOUNT
• In discounting at a simple interest, the difference D = S – P is called the simple discount D either as the interest I on P
which when added to P gives S, or as the true discount on S which when subtracted from S gives P.

• The discount rate d for a year is the ratio of the discount D for the year to the amount S on which the discount is given.
The simple discount D on the amount S, also called bank discount, for t years at the discount rate d is calculated by
means of the formula

• And the discount value, or proceeds, P of S is given by

• The charge for some short-term loans may be based on the final amount rather than the present value. The lender
calculates the bank discount D on the final amount S that must be paid on the due date and deducts it from S; the
borrower receives the proceeds P. For this reason, bank discount is sometimes called interest in advance.
SIMPLE DISCOUNT

• And is used to calculate the maturity value of a loan for specified proceeds.

• A discount rate d and an interest rate r are equivalent(over time t) if they result in the same preset value P
for an amount S due in future. We derive a formula for the simple interest rate r equivalent to a simple
discount rate d:

• Solving for d, we obtain the rate of simple discount equivalent (over time t) to a rate of simple interest r:
Example 1
• Find the present value at 12% simple interest of $1000 due in 5 months. What is the true discount?

• Solution:

• We have S = 1000, r = 0.12 and t = 5/12.

• The true discount is D = S – P = 1000 – 952.38 = $47.62

Example 2
• Find the present value at 12% simple discount of $1000 due in 5
months. What is the simple discount?

• Solution:

• We have S = 1000, d = 0.12, and t = 5/12

• The simple discount is D = S – P =1000 – 950 = $50

Example 3
• A bank charges 12% simple interest in advance (that is, 12% bank discount) on short term loans. Find the
sum received by the borrower who requests (a) $900 for 90 days, (b) $1500 from May 3 to October 15.

• Solution:

(a)
Example 4
• Flex Bank Plc bids 92.823 for a 91-day, K1 000 000 Treasury bill. (This means that the
bank is willing to pay K928,230 for the bill which will mature 91 days from the date of
issuance to a value of K1 000 000). If the bid is accepted, what will the bank get , on (a)
bank discount basis (b) A simple interest basis?

• Solution:

(a) We have D = 1000000 – 928 230 = 71 770, S = 1 000 000, and t = 91/360

(b) We have I =71 770, P = 928 230, and t = 91/360

COMPOUND INTEREST AND
COMPOUND DISCOUNT
ACCUMULATED VALUE

• If the interest due is added to the principal at the end of each interest period and thereafter earns interest,
the interest is said to be compounded. The sum of the original principal and total interest is called the
compound amount or accumulated value. The difference between the accumulated value and the original
principal is called the compound interest. The interest period, the tie between two successive interest
computations, is also called the conversion period.

• Interest may be converted into principal annually, semiannually, quarterly, monthly, weekly, daily, or
continuously. The number of times interest is converted in one year, or compounded per year, is called the
frequency of conversion. The rate of interest is usually stated as an annual interest rate, referred to as the
nominal rate of interest. The phrase “interest at 12%” or “money worth 12%” means 12% compounded
annually, otherwise the frequency of conversion is indicated, e.g., 16% compounded semiannually, 10%
compounded daily. When compounding daily, most U.S. Banks use 365-day year.
ACCUMULATED VALUE
• The following notation will be used:

• P original principal, or the present value of S, or the discounted value of S

• S compound amount of P, or the accumulated value of P

• n total number of interest (or conversion) periods involved

• m number of interests period per year, or the frequency of compounding

• Nominal (yearly) interest rate which is compounded (payable, convertible) m times per year (in some textbooks the
nominal interest rate is denoted )

• Interest rate per interest period.

• The interest rate per period, , equals . For example, = 12% means that a nominal (yearly) rate of 12% is converted
(compounded, payable) 12 times per year, being the interest rate per month.
ACCUMULATED VALUE
• Let represent the principal at the beginning of the first interest period and the interest rate per conversion
period. We shall calculate the accumulated values at the ends of successive interest periods for n periods.

• At the end of the 1st period:

• Interest due

• Accumulated value

• At the end of the second period:

• Interest due

• Accumulated value
ACCUMULATED VALUE
• At the end of the 3rd period:

• Interest due

• Accumulated value

• Continuing in this manner, we see that the successive accumulated values, form a geometric sequence whose nth
term is

• Where S is the accumulated value of P at the end of n interest periods. The formula above is the fundamental
formula for compound interest. The process of calculating S from P is called accumulation, and the factor is called
the accumulation factor or the accumulated value of K1.

• The accumulated value of S of principal P at the rate for t years is

Example 1

• Find (a) the simple interest on K1000 for 2 years at 12% (b) the compound interest of K1000 for 2 years at
12% semiannually.

• Solution:

(a)

• I = S – P = K1262.48 – K1000 = K262.48

Example 2
• Find the compound interest on K1000 at (a) (b)

• Solution:

(a) We have P = 1000,

(b) We have P = 1000,

Example 3
A person deposited K1000 into a retirement savings plan on February 4, 1978. How much money will be in the
plan on February 4,1998, at 11.4% compounded daily, assuming (a) approximate time (1year =360 days)
(b) exact time (1year =365 days)

• Solution:

(a) We have

(b) We have

• The result differs from that of (a) by only 5 ngwee.

Example 4
Fifteen thousand kwacha is invested for 18 months at a nominal rate of 13%. Find the accumulated value if
interest is compounded (a) monthly (b) continuously

• Solutions:
Example 5
Two thousand kwacha is invested for 10 years at for the first 3 years, at for the next 4 years, and at for the last
3 years. Find the accumulated value after 10 years.

Solutions:

• Accumulated value after 3 years =

• Accumulated value after 7 years =

• Accumulated value after 10 years =

• This solution may also be expressed as;

Example 6

The population of kafue town was 15000 on December 31, 1980. During the period 1980 to 1990 the town
grew at the rate of 2% per annum. Assuming the rate of growth remains constant, estimate (a) the population
on December 31, 2000 (b) the increase in population in the year 1998.

• Solution:

(a) P = 15 000,

(b) Estimated population on December 31,1997 =

• Then the estimated increase in population in the year is 2% of 21004, or 420.

 ANNUITIES
An annuity is a constant sum of money received or paid
each year for a given number of years.
Example

Find the present value of a three year annuity of $100

which begins in one year’s time when interest rates are
5%.
Solution:
Present value of an annuity = annuity x Annuity factor.
Annuity factor =
Therefore, Present value of the annuity = 2.723 x $100
=$272.30
 PERPETUITIES
A perpetuity is an annuity which lasts forever.
The present value of a perpetuity =
Example

Ruckeen is to receive $2000 per annum when he retires

in perpetuity stating in one year’s time. If the annual rate
of interest is 9%, what is the present value of this
perpetuity?
CASH FLOWS AND PROFITS
• To be successful in business, organisations must make
profits. Profits are needed in order to pay dividends to
shareholders and to allow partners to make drawings.
• If an organisation makes a loss, the value of the
business falls and if there are long term losses, the
business may eventually collapse.
• Net profit measures how much the capital of an
organisation has increased over a period of time. Profit
is calculated by applying the matching concept, that is
to say by matching costs incurred with the sales
revenue generated during a period.
THE IMPORTANCE OF CASH
In addition to being profitable, an organisation needs to
have enough cash in order to pay for the following:
• Goods and services
• Capital investment(plant, machinery and so on)
• Labour costs
• Dividends
Net cash flow measures the difference in the payments
leaving an organisation’s bank account and the receipts
that are paid into the bank account.
NET PROFIT AND NET CASH FLOW
Reasons why net profit and net cash flow differ are
mainly due to timing differences.
(a)Purchas of non-current assets suppose an
asset is purchased for $20,000 and depreciation is
charged at 10% of the original cost.
• Cash payment during the year = $20,000 (and this does
not affect the statement of profit or loss)
• Depreciation charged = 10% x $20,000 = $2000. this is
charged to the statement of profit or loss and will
reduce overall profits.
NET PROFIT AND NET CASH FLOW
(b) Sale of non-current assets
When an asset is sold there is usually profit or loss on
sale. Suppose an asset with a net book value of $15,000
is sold for $11,000, giving rise to a loss on disposal of
$4,000.
• Increase in cash flow during the year =$11,000 sale
proceeds. There will be no effect on the statement of
profit or loss.
• Loss on sale of non-currents = $4000. this will be
recorded in the firm’s statement of profit or loss and will
reduce overall profits.
NET PROFIT AND NET CASH FLOW
© Matching receipts from receivables and sales invoices raised.
If goods are sold on credit, the cash receipts will be the same as
the value of sales(ignoring any early settlement discounts and bad
debts).However, receipts may occur in a different period as the
result of the timing of payments.
(d) Matching payments to payables and cost of sales.
If materials are bought on credit, the cash payment to suppliers
will be the same as the value of materials purchased. Again the
payments may be in different periods due to timing. Materials
purchase are matched against sales in a particular period to
calculate profit, demonstrating that profit and cash flow will differ
in a particular period.
CASH FLOW IN CAPITAL INVESTMENT
APPRAISAL
In capital investment appraisal situation, the driver of long-
term value is cash flow. In particular the timing and amount of
cash received or paid is used in the evaluation rather than an
assessment of profit (or loss) which is a short-term measure
often used to assess value.
EXAM FOCUS
It is important that you fully understand the difference between
cash and profit. The examiner has noted that this is a problem
for many candidates. The key differences are covered by points
(a) and (b) above. Points © and (d) are relevant to the
examination of short term differences such as cash
budgeting/forecasting.
CAPITAL INVESTMENT APPRAISAL-
NET PRESENT VALUE METHOD(NPV)
• Discounted cash flow involves discounting future cash flows from
a project in order to decide whether the project will earn a
satisfactory rate of return.
• The two main discounted cash flow methods are the net present
value (NPV) method and the internal rate of return (IRR) method.
• Discounted cash flow methods can be used to appraise capital
investment projects.
• The net present value method calculates the present values of all
items of income and expenditure related to an investment at a
given rate of return, and then calculates a net total. If it is
positive, the investment is considered to be acceptable. If it is
negative the investment is considered to be unacceptable.
THE COST OF CAPITAL
The cost of capital has two aspects to it
(a)It is the cost of funds that a company raises and uses.
(b)The return that investors expect to be paid for putting
funds into the company. It is therefore the minimum
return that a company should make from its own
investments, to earn the cash flows out of which
investors can be paid their return.
The cost of capital can therefore be measured by
studying the required by investors, and used to derive a
discount rate for discounted cash flow analysis and
investment appraisal.
EXAMPLE
Dog Co is considering whether to spend $5,000 on an
item of equipment which will last for two years. The
excess of cash received from the equipment over cash
expenditure from the equipment would be $3,000 in the
first year and $4,000 in the second year.
Required
Calculate the net present value of the investment in the
equipment at a discount rate of 15%.
TIMING OF CASH FLOW
Note that annuity tables and the formulae assume that
the first payment or receipt is a year from now. Always
check examination and assessment questions for when
the first payment falls.
For example, if there are five equal annual payments
starting now, and the interest rate is 8%, we should use a
factor of 1(for today’s payment) + 3.312(for the other
four payments) = 4.312.
CASH vs PROFIT
Remember that it is the cash flow figures that must be
included in your calculations. If depreciation has been
deducted to arrive at a profit figure, it must be added
back to give the net cash inflow.
QUESTION 1
Daisy Co is considering whether to make an investment
costing $28,000 which would earn a profit of $2,400 per
annum for each of the next five years, after charging
depreciation at a straight line rate over five years, to a
residual value of $0.
Required
What is the net present value of the investment at a cost
of capital of 11%.
QUESTION 2
VBX Co is considering a project which would cost $50,000
now and yield $9,000 per annum in perpetuity, starting a
year from now. The cost of capital is 15%.
Required
Calculate the net present value of the project.
WHAT DOES A NET PRESENT VALUE
MEAN?
• The net present value is a measure of the value in terms
of ‘today’s money’ of the net benefits from a proposed
investment. The discount rate is the rate of return that
will be sufficient to cover the cost of the organisation’s
capital.
• If an organisation with a positive NPV goes ahead it will
add value to the organisation, because the value of its
net returns will be more than are needed to satisfy the
providers of capital to the organisation.
• In theory, the value of the organistion should increase
by the amount of the NPV if the investment go ahead.
CAPITAL INVESTMENT APPAISAL-
INTERNAL RATE OF RETURN(IRR)
METHOD.
• The IRR method determines the rate of interest(internal
rate of return) at which the NPV = 0. The internal rate of
return is therefore the rate of return on an investment.
• The internal rate of return method of evaluating
investments is an alternative to the NPV method. The
NPV method of discounted cash flow determines
whether an investment earns a positive or a negative
NPV when discounted at agiven rate of interest. If the
NPV is zero(i.e the present value of costs and benefits
are equal) the return from the project would be exactly
the rate used for discounting.
CAPITAL INVESTMENT APPAISAL-
INTERNAL RATE OF RETURN(IRR)
METHOD.
• The internal rate of return will indicate that a project is
viable if the IRR exceeds the minimum acceptable rate
of return. Thus if a company expects a minimum of 15%
return on a project, the project will only be viable if its
IRR exceeds 15%.
• Example:
If $500 is invested today and generates $600 in one
year’s time, the internal rate of return (r) can be
calculated as follows:
THE INTERPOLATION METHOD
Using the interpolation method, the IRR is calculated by
first of all finding the NPV at each of the interest rates.
Ideally, one interest rate should give a positive NPV and
the other should give a negative NPV. The internal rate of
return would then be somewhere between these two
interest rates: above the rate where the NPV is positve,
but below the rate where the NPV is negative. However,
it is still possible to use two positve values or two
negative values to extrapolate the IRR.
THE INTERPOLATION METHOD
•%

Where a is one interest rate

b is the other interest rate
is the NPV at rate a
is the NPV at rate b
QUESTION 1
The net present value of an investment at 16% is +
$50,000 and at 20% is + $10,000. the internal rate of
return of this investment is:
A 19%
B 20%
C 21%
D 22%
QUESTION 2
The net present value of an investment at 18% is -
$14,000 and at 14% is -$5,000. The internal rate of
return of this investment is:
A 13%
B 12%
C 11%
D 10%
THE INTERPOLATION METHOD-
CONSTANT ANNUAL CASH FLOWS
AND ANNUITY
When the cash flows from a project are a constant amount each year,
the internal rate of return can be calculated using the interpolation
formula and annuity factors.
The IRR can be calculated using the following formula:

Where a is the lower discount factor

b is the higher discount factor
CDFa is the cumulative discount factor(annuity factor) at a lower
discount rate
CDFb is the cumulative discount factor (annuity factor) at a higher
discount rate.
CDFiirr is the cumulative discount factor where the NPV = 0.
QUESTION 1
An investment will cost $75,000 and is expected to
provide a cash return of $20,000 each year for the next
six years. What is the IRR of the investment?
What does the IRR of an investment
mean?
In theory the value of an organisation should increase by
the NPV of the investments that it undertakes. The
internal rate of return of an investment is a measure of
the return that the investment is expected to achieve. If
the IRR is more than the cost of capital, the investment
should go ahead.
However, unlike the NPV of investments, the IRR does not
provide a measure of how much value the investment will
create. A project with an NPV of +$1 million and an IRR of
15% is more valuable than a project of NPV of +$100,000
and an IRR of 25%. The project with a higher NPV will
create more value.
CAPITAL INVESTMENT APPRAISAL-
PAYBACK METHOD.
• The payback period is the time that is required for the
cash inflows from a capital investment project to equal
the cash outflows.
• Before the payback period can be calculated,
management must have details of the following:
The initial cash outflow for the project under
consideration
Estimates of any future cash inflows or savings.
PAYBACK PERIOD
Ruby Co is considering a new project which will require
an initial investment $60,000. the estimated profit before
depreciation are as follows:
Year estimated net cash inflows
1 $20,000
2 $30,000
3 $40,000
4 $50,000
5 $60,000
USING THE PAYBACK PERIOD TO
APPRAISE CAPITAL INVESTMENT
PROJECTS
There are two ways in which the payback period can be
used to appraise projects.
(a)If two or more mutually exclusive projects are under
consideration, the usual decision is to accept the
project with the shortest payback period.
(b)If the management of a company have a payback
period limit, then only projects with payback periods
which are less than this limit would be considered for
investment.
EXAMPLE
Suppose Ruby Co has a payback period limit of two
years, and is considering investing in one of the following
projects, both of which require an initial investment of
$400,000. cash flows accrue evenly through out the year.
PROJECT A PROJECT B

Year Cash in flow Year Cash inflow

1 100,000 1 200,000

2 200,000 2 180,000

3 100,000 3 120,000

4 150,000 4 100,000

5 150,000 5 100,000
REQUIRED
Which project is acceptable from the point of view of the
payback period?
WHAT DOES PAYBACK MEAN?
The payback for an investment is a measure of how long
it will take to recover the initial cash spending on an
investment. If an organisation has cash flow difficulties,
payback may be an important consideration. Similarly,
payback may be a way of avoiding investments in
projects where the expected cash flows are difficult to
estimate reliably, especially more than a few years into
the future.
However, payback does not measure the value of an
investment, or the expected return on investment that
will provide. It ignores all cash flows and returns after
payback has been achieved.
WHAT DOES PAYBACK MEAN?
Payback is often used as an initial step in appraising a
project. However, a project should not be evaluated on
the basis of payback alone. If the project passes the
payback test, then it should be evaluated further with a
more sophisticated project technique such as NPV or IRR.
DISCOUNTED PAYBACK PERIOD
Payback can be combined with DCF, and a discounted
payback calculated. The discounted payback period is
the time it will take before a project’s cumulative NPV
turns from negative to positive.
Example
A project has a cost of capital of 10% and the following
cash flows. Calculate the discounted payback period.
year Cash flow

0 (100,000)

1 30,000

2 50,000

3 40,000

4 30,000

5 20,000