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these:

How long does it take to recover the investments?

How long does it take for cash inflows to cover the initial costs?

Or, put still another way: How long does it take to break even?

The investment that is repaid in the shorter time period is considered the better choice.

The shorter time period is preferred because:

Investment or action costs are recovered sooner and are available again for further use.

A shorter payback period is viewed as less risky.

The longer the time required for covering initial investment, the more uncertain are the positive

returns. For this reason, Payback period is often viewed as a measure of risk, or a risk-related

criterion that must be met before funds are spent.

As an example, consider a five (5) year investment whose cash flow are summarized in the table

below. The primary data for calculating payback period are the expected cash inflows and

outflows.

Expected Cash Flow Year 0 Year 1 Year 2 Year 3 Year 4

Cash Inflows 0 200 400 500 500

Cash Outflows 800 150 0 0 0

Net Cash Flow 800 50 400 500 500

Cumulative CF 800 750 350 +150 +650

At what point in time does the investment break even?

Look first to cumulative cash flow. It is clear that payback occurs sometime in Year 3.

We know it occurs in Year 3 because cumulative cash flow is negative at Year 2 and positive at Year 3.

But where, precisely, is the break even event in Year 3? The answer can be seen roughly on a graph,

showing Payback as the point in time when cumulative cash flow crosses from negative to positive.

Year

(n)

Net cash

flow ($)

Discount factor

(10%)

Discounted cash flow

($)

Cumulative discounted

cash flow ($)

0 -800 1/[1+i]

n

= 1/[1.1]

0

= 1.000 -800 -800

1 50 1/[1+i]

n

= 1/[1.1]

1

= 0.9091 45 -755

2 400 1/[1+i]

n

= 1/[1.1]

2

= 0.8264 330 -425

3 500 1/[1+i]

n

= 1/[1.1]

3

= 0.7513 376 -49

4 500 1/[1+i]

n

= 1/[1.1]

4

= 0.6830 341 +292

The discounted payback period occurs in Year 4 because discounted cumulative cash flow is negative at

Year 3 and positive at Year 4.

Profitability index (PI), also known as profit investment ratio (PIR) and value investment

ratio (VIR), is the ratio of payoff to investment of a proposed project. It is a useful tool for

ranking projects because it allows you to quantify the amount of value created per unit of

investment.

The ratio is calculated as follows:

Profit-to-investment ratio = undiscounted profit / investment

[Does not consider discount rate]

Discounted Profit-to-investment ratio = discounted profit / investment

[Consider discount rate]

The profit calculated above does not include the investment. As the value of the profitability

index increases, so does the financial attractiveness of the proposed project.

Rules for selection or rejection of a project:

If PIR > 1 then accept the project

If PIR < 1 then reject the project

If PIR = 1 indicates breakeven

Example:

Year

(n)

Net cash flow

($)

Discount factor

(10%)

Discounted cash flow

($)

0 -2,520,000 1/[1+i]

n

= 1/[1.1]

0

= 1.000 -2,520,000

1 1,200,000 1/[1+i]

n

= 1/[1.1]

1

= 0.9091 1,090,920

2 1,500,000 1/[1+i]

n

= 1/[1.1]

2

= 0.8264 1,239,600

3 1,000,000 1/[1+i]

n

= 1/[1.1]

3

= 0.7513 751,300

4 850,000 1/[1+i]

n

= 1/[1.1]

4

= 0.6830 580,550

5 750,000 1/[1+i]

n

= 1/[1.1]

5

= 0.6209 465,675

Undiscounted profit

=$ 5,300,000

Discounted profit

= $ 4,128,045

a. PIR = $5,300,000 / $2,520,000 = 2.103

b. Discounted PIR = $4,128,045 / $2,520,000 = 1.638

Both PIR > 1, therefore the project is profitable.

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