Transcript Payback Period
Lecture No.15
Chapter 5 Contemporary Engineering Economics Copyright © 2010 Contemporary Engineering Economics, 5 th edition, © 2010
Chapter Opening Story – GE’s Healthymagination Project GE Unveils $6 Billion Health-Unit Plan:
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Goal: Increase the market share in the healthcare sector.
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Strategies: Develop products that will lower costs, increase access and improve health-care quality.
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Investment required: $6 billion over six years
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Desired project outcome: Would help GE’s health-care unit grow at least twice as fast as the broader economy.
Contemporary Engineering Economics, 5 th edition, © 2010
Ultimate Questions
GE’ s Point of View:
Would there be enough demand for their products to justify the investment required in new facilities and marketing?
What would be the potential financial risk if the actual demand is far less than its forecast or adoption of technology is too slow?
If everything goes as planned, how long does it take to recover the initial investment?
Contemporary Engineering Economics, 5 th edition, © 2010
Bank Loan vs. Project Cash Flows
Contemporary Engineering Economics, 5 th edition, © 2010
Example 5.1 Describing Project Cash Flows – A Computer-Process Control Project
Year (n) Cash Inflows (Benefits) Cash Outflows (Costs) Net Cash Flows 0 1 2 … 8 0 215,500 215,500 … 215,500 $650,000 53,000 53,000 … 53,000 -$650,000 162,500 162,500 … 162,500
Contemporary Engineering Economics, 5 th edition, © 2010
Cash Flow Diagram for the Computer Process Control Project
Contemporary Engineering Economics, 5 th edition, © 2010
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 bench-mark period, the project would be considered for further analysis.
Weakness : Does not consider the time value of money
Contemporary Engineering Economics, 5 th edition, © 2010
Example 5.3 Payback Period
N
Cash Flow Cum. Flow 0 1 2 3 4 5 6 -$105,000+$20,000 $15,000 $25,000 $35,000 $45,000 $45,000 $35,000 -$85,000 -$70,000 -$45,000 -$10,000 $35,000 $80,000 $115,000 Payback period should occurs somewhere between N = 3 and N = 4.
Contemporary Engineering Economics, 5 th edition, © 2010
$25,000 $35,000 $45,000 $45,000 $35,000 0 $15,000 1 $85,000 150,000 100,000 50,000 0 -50,000 -100,000 0 2 Years 3.2 years Payback period 3 4 5 1 2 3 4 Contemporary Engineering Economics, 5 th edition, © 2010 5 Years (
n
) 6 6
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, 5 th edition, © 2010
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 bench-mark period, the project could be considered for further analysis.
Weakness : Cash flows occurring after DPP are ignored
Contemporary Engineering Economics, 5 th edition, © 2010
Discounted Payback Period Calculation
Period (n) 0 1 2 3 4 5 6 Cash Flow (A
n
) -$85,000 15,000 25,000 35,000 45,000 45,000 35,000 Cost of Funds (15%)* 0 -$85,000(0.15) = -$12,750 -$82,750(0.15) = -12,413 -$70,163(0.15) = -10,524 -$45,687(0.15) =-6,853 -$7,540(0.15) = -1,131 $36,329(0.15) = 5,449 Ending Cash Balance -$85,000 -82,750 -70,163 -45,687 -7,540 36,329 76,778
*
Cost of funds = (Unrecovered beginning balance) X (interest rate)
Contemporary Engineering Economics, 5 th edition, © 2010
Illustration of Discounted Payback Period
Contemporary Engineering Economics, 5 th edition, © 2010
Payback periods can be used as a screening tool for liquidity, but we need a measure of investment worth for profitability.
Contemporary Engineering Economics, 5 th edition, © 2010