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C a l c u l a t i n g N e t P r e s e n t Va l u e , P a y b a c k Pe r i o d , a n d R e t u r n o n I n v e s t m e n t

A capital investment is an expenditure by an organization in equipment, land, or other assets that are used to carry out the objectives of the organization. Since money—including money available for capital investment—is a scarce resource, one important responsibility of senior-level management of any organization is to decide which of the available alternative investments to choose. Organizations use several different methods to determine which investment is best. The three methods this appendix discusses are net present value (NPV), payback period, and return on investment (ROI). Definitions and brief explanations of these terms are given in Chapter 3. This appendix explains these measures in more detail and shows how to calculate them. More in-depth discussion of the principles behind these measurements, including important concepts about selecting alternatives, can be found in books on finance. You can calculate these measurements by hand using tables for rates and factors. In addition, financial calculators now have built-in function keys to calculate these measures. This appendix demonstrates the manual method to provide an understanding of the principles.

**NET PRESENT VALUE CALCULATIONS
**

The two basic concepts of net present value are (1) that all benefits and costs are calculated in terms of today’s dollars (that is, present value) and (2) that benefits and costs are combined to give a net value. Hence the name net present value. The first step in calculating the NPV is to decide on the discount rate to use. Most organizations have a policy, determined by the chief financial officer, that states the standard discount rate used for investments. This rate may vary by type of investment—we will use the discount rate for software development. The discount rate equates future values to current values. For example, $100 received one year in the future is only worth $94.34 today with a discount rate of .06 (6 percent). The equation that represents this is present value = amount received in future / (1 + discount interest rate) number of years discount factor

the accumulation of yearly discounts based on the discount rate

discount rate

the annual percentage rate that an amount of money is discounted to bring it to a present value

For dollar amounts received more than one year in the future—for example, in three years—the discount rate is applied three times to give a discount factor. Let’s use PV for present value, FV for future value, i for discount interest rate, F for discount factor, and n for the number of years in the future. The equations that apply to find a present value for a future value across multiple years are

F n = 1/(1 + i) n and PV = FV * F n

**For example, $100 received three years hence at a discount rate of 6 percent is
**

F n = 1/[(1+ .06) * (1+ .06) * (1+ .06)] = .8396 PV = $100.00 * .8396 = $ 83.96

C-1

Appendix C

C a l c u l a t i n g N e t P r e s e n t V a l u e , Pa y b a c k P e r i o d , a n d R e t u r n o n I n v e s t m e n t

988 $ 1. In the figure. Figure C-1 shows the table containing the NPV calculations that were done for Rocky Mountain Outfitters (RMO) in Chapter 3. All of the development costs are assigned to year 0 even if the development project spans multiple years.139.18% The anticipated benefits are also associated with the year in which they accrue.253.667.559)) / (1. Thus. Line 4 shows the development costs.190 $ 941. Most organizations have an investment policy that determines the time period allowed for NPV calculations.000) $ (746. since as the system gets older. RMO anticipates that these benefits will increase over time with increased usage and utility from the system.000 0.000) 0.000 0.893 – (1.000) 4 $ (1.000 0.737 9 10 11 $ (1.9091 $ (241.000) 5 6 $ (241.000 0.6830 $ 2. Notice that the NPV calculation is done over a period of five years.122.405 $ 1. Finance books provide tables of discount factors by discount rate for multiple years.000) $ 589.000) 0.637) $ (913.107 $ 956.334 2 years + 4796 / (4796 + 951. Year 0 is considered to be the period at the beginning of the useful life of the system—that is.374 $ (1.796) $ 951.893 3 $ - $ 808.559) = 172.873.6209 7 $ $ (219. Line 1 in Figure C-1 shows the annual benefits of the new system.000 + 913. payback.162) $ (181. RMO cost benefit analysis 1 2 Value of benefits Discount factor (10%) Present value of benefits Development costs Ongoing costs Discount factor (10%) Present value of costs PV of net of benefits and costs Cumulative NPV Payback period 5-year return on investment 1 $ 1 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Total - $ 889. so you simply enter the future value. a n d R e t u r n o n I n v e s t m e n t C-2 . and return on investment calculations for RMO.122.6209 $ 6.336.137. as shown on line 5. Pa y b a c k P e r i o d .000) 0. Operating costs normally increase over time. and the number of years to get the present value. so you do not have to calculate them.468 $ 1.609) = 2 + .9091 $ 1.591 $ 1.7513 $ 2.077. Annual operating costs.597 $ 3.7513 $ (241. the point in time of the initial investment.418.APPENDIX C F I G U R E C-1 Net present value.000 + 913.8264 $ (241.8264 $ 1.514. are applied to the year in which they occur. Appendix C C a l c u l a t i n g N e t P r e s e n t V a l u e .603) $ (149.005 or 2 years and 2 days (6. In this example.907 $ 742.205.927. year 0 is considered the present year. it frequently requires more maintenance.000) 0. Notice that these benefits begin in year 1.093) $ (199.336.817.336. RMO policy states that an investment in a new information system must have a positive value within at most five years.000 0.336.270 $ 1. the discount rate.000) 0.604 $ 2. Financial calculators have the preceding equations built-in.336.063) $ (164.336.903) $ (4.6830 $ (241. the NPV calculations cover a five-year period.559) 8 $ (1.

and line 7 has the present value of the future operating costs. For RMO.796 and ended the year with a positive value of $951. On line 3 is the present value of each of the future annual benefits. the discount rate). the factor reduces since it is a continual multiplication of the previous year’s factor by 1/(1 + discount rate).005 Payback thus occurs in 2.334. The objective of the return on investment is to calculate a percentage return (like an interest rate) so that the costs and the benefits are exactly equal over the specified time period. we have used a discount rate of 10 percent. the productive life of the system). You can calculate the payback period using either present value amounts or cash flow amounts. To obtain the net present value across all the years. the total NPV for this investment is $3. The equation for the fraction of a year is (|beginning-year amount| / (year-end amount + |beginning-year amount| )) where the vertical bars indicate absolute value. Various methods are used to calculate payback. at the end of five years. The time period can be the expected life of the investment (that is. the fraction of a year before payback is (4796 / (951. a n d R e t u r n o n I n v e s t m e n t . this happens within the third year. or you can apply the discount factor to the benefits and costs individually and then combine the two discounted amounts. RETURN ON INVESTMENT The objective of the NPV is to determine a specific value based on a predetermined discount rate. (You will see the reason later when we discuss ROI. In our example. you combine the amounts in each column of row 8. In the RMO example. Finally. Notice that in year 0. Figure C-1 shows a running accumulation. and also use net benefits (that is. line 8 combines lines 3 and 7 for each year of the benefits and costs.609 + 4796) ) = .APPENDIX C You can apply the next two steps in either order: You can either combine the benefits and costs (net them together) and then apply the discount factor.873. Each year thereafter. the third year began with a deficit of $4. benefits minus operating costs). The year when this value goes positive is the year in which payback occurs.005 * 365). the payback period is two years and two days (. which is the present. we use the time value of money (that is. The discount factors are given in line 2 and repeated on line 6. Figure C-1 illustrates a return on investment calculation for RMO. You can obtain a more precise answer by determining the fraction of a year when payback actually occurs. As the figure shows.609.) In the example.00. In this example. Pa y b a c k P e r i o d . This example simply calculates the ROI C-3 Appendix C C a l c u l a t i n g N e t P r e s e n t V a l u e . Another approach is to consider only the initial investment and not include annual operating costs in the calculations. the discount factor is 1. PAYBACK PERIOD CALCULATIONS Payback is a method to determine the point in time at which the initial investment is paid off. Therefore. in row 9. This example uses the second approach and discounts the benefits and costs separately before combining them.005 years. or it can be an arbitrary time period. Cash flow amounts do not take the time value of money into consideration and only calculate based on nondiscounted dollar amounts. year by year.

5833 C a l c u l a t i n g N e t P r e s e n t $8.000.APPENDIX C for the five-year period.000 $80. the investment in the development costs returned over 172 percent on the investment for a period of five years. 3. assuming the system will be functional for at least 10 years.000 + 913. These numbers are given on the last column in the table. p.9259 .000 $80. Pa y b a c k P e r i o d . a n d R e t u r n o.000 $7. Net benefits and costs together first. In another situation.000 $7.000 $75.336. What is the difference between the following two procedures? a. p.7938 .336. Year 1 2 3 4 5 6 7 8 Anticipated Annual Benefits $55. How do you determine the time period for NPV? For ROI? 4. a n d R e t u r n o n I n v e s t m e n t C-4 .500 $5. then discount the combined figure to get a net present value. Calculate the net present value.000 $60. if we assume the lifetime was longer.7349 .000 + 913. Pa y b a c k P e r i o d . The process is to use the amounts for the discounted benefits and the discounted costs.893 – (1.18% In other words.000 $80. b.6301 . Line 11 of Figure C-1 contains the calculations for a five-year return on investment. since the system is generating benefits at that point in time.000 .6805 .000 $80.122.500 $7. The development costs for the system were $225. Obviously. then net these values together to get a net present value.5401v e s t m e n t Va l u e n In C-5 Appendix C C a l c u l a t i n g N e t P r e s e n t V a l u e . 776 REVIEW QUESTIONS 1.559)) / (1. The equation to calculate ROI is ROI = (Estimated time period Benefits – Estimated time period Costs) / Estimated time period Costs For RMO. Explain the difference between the discount rate and the discount factor.000 $70.000 Discount Factors at 8 Percent . RMO might want to consider a 10-year ROI. 2.559) = 172.000 Appendix C Expected Annual Operating Costs $5. and the return on investment using a discount rate of 8 percent for the following systems development project. the ROI is ROI = (6. 776 discount factor. assuming a five-year benefit period. KEY TERMS discount rate. Discount benefits and discount costs first. the payback period. What is meant by payback period? T H I N K I N G C R I T I C A L LY 1.8573 .000 $5. we would get a much higher ROI.000 $5.

APPENDIX C C-6 Appendix C Principles of Project Management .

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