Faversham Fish Farm

PAYBACK PERIOD
Year Cash Flow Cash Flow Kumulatif
0 100,000
1 34,432 34,432
2 39,530 73,962
3 39,359 113,321
4 32,219 145,540
Payback Period a + (b - c)/d
2.66

INTERNAL RATE OF RETURN (IRR)

DCF 15%
PVIF 1/(1+i)^n
YEAR NET CASH FLOW PVIF AT 15% PRESENT VALUE
1 34,432 0.87 29,955.84
2 39,530 0.76 29,884.68
3 39,359 0.66 25,898.22
4 32,219 0.57 18,429.27
104,168.01

DCF 20%
PVIF 1/(1+i)^n
YEAR NET CASH FLOW PVIF 20% PRESENT VALUE
1 34,432 0.833 28,681.86
2 39,530 0.694 27,433.82
3 39,359 0.579 22,788.86
4 32,219 0.482 15,529.56
94,434.10

INTERPOLATON BETWEEN 15% AND 20%

5%

PV 15% > ICO > PV 20%

104,168.01 $ 100,000 94,434.10

4,168.01

9,733.92

X 4,168.01
= X
 = X
5% 9,733.92

IRR = 17.14%

NET PRESENT VALUE

DCF 12%
ICO 100,000
PVIF 1/(1+i)^n
YEAR NET CASH FLOW PVIF 12% PRESENT VALUE
1 34,432 0.893 30,748
2 39,530 0.797 31,505
3 39,359 0.712 28,024
4 32,219 0.636 20,491
110,768

NPV 10,768 (Greater than zero) DITERIMA

PROFITABILITY INDEX (PI)

PI 1.11
aversham Fish Farm

The payback period (PBP) of an investment project

tells us the number of years required to recover our
initial cash investment based on the project’s expected
cash flows. Suppose that we wish to determine the
payback period for the new fish-flaking facility
discussed in the last chapter. We determined, at that
time, that for an initial cash outflow of $100,000, the
Faversham Fish Farm expected to generate net cash
flows of $34,432, $39,530, $39,359, and $32,219 over
the next 4 years.

To illustrate, again consider our example. We want to

determine the discount rate that sets the present
value of the future net cash-flow stream equal to the
initial cash outflow. Suppose that we start with a 15%
discount rate and calculate the present value of the
cash-flow stream.

A 15% discount rate produces a resulting present value

for the project that is greater than the initial cash
outflow of $100,000. Therefore, we need to try a
higher discount rate to further handicap the future
cash flows and force their present value down to
$100,000. How about a 20% discount rate ?

This time the discount rate chosen was too large. The
resulting present value is less than the hoped-for
$100,000 figure. The discount rate necessary to
discount the cash-flow stream to $100,000 must,
therefore, fall somewhere between 15% and 20%

= 0.0214
= 0.0214

If an investment project’s net present value is zero or more, the project is

accepted; if not, it is rejected. Another way to express the acceptance criterion is
to say that the project will be accepted if the present value of cash inflows
exceeds the present value of cash outflows. When the discount rate is zero, net
present value is simply the total cash inflows less the total cash outflows of the
project. Assuming a conventional project – one where total inflows exceed total
outflows and where the initial outflow(s) is (are) followed by inflows – the highest
net present value will occur when the discount rate is zero. As the discount rate
increases, the net present value profile slopes downward to the right.

As long as the profitability index is 1.00

or greater, the investment proposal is
acceptable.
Internal Rate of Return (IRR) 100% 25%
NET CASH FLOW
END OF YEAR
PROJECT S PROJECT L
0 $ 100 $ 100,000
1 - -
2 400 156,250

Rate of Return 10%

NET CASH FLOW
END OF YEAR PV
PROJECT S PVIF 10%
0 $ 100
1 - 0.9091 -
2 400 0.8264 331
NPV 231
PI 3.31

NET CASH FLOW

END OF YEAR PV
PROJECT L PVIF 10%
0 $ 100,000
1 0 0.9091 0
2 156250 0.8264 129,132
NPV 29,132
PI 1.29

Ranking the projects based on our result reveals

IRR NPV 10% PI AT 10%
PROJECT S 100% 231 3.31
PROJECT L 25% 29,132 1.29
RANKING 1 S L S
RANKING 2 L S L
A problem sometimes arises if the initial cash outflows are different for
mutually exclusive investment projects. Suppose a firm had two mutually
exclusive investment proposals that were expected to generate the
following net cash flows

Internal rates of return for projects S (the small project) and L (the large
project) are 100 percent and 25 percent, respectively. If the required rate of
return is 10 percent, the net present value of project S is $231, and its
profitability index is 3.31. For project L the net present value is $29,132 with
a corresponding profitability index of 1.29
 NET CASH FLOW
END OF YEAR
PROJECT D PROJECT I
0 -1200 -1200 Internal rates of return for pro
respectively. For every discoun
1 1000 100 net present value and profitab
2 500 600 project I. On the other hand, fo
3 100 1080 percent, project I’s net presen
than those for project D. If we
IRR 23% 17% percent, each project will have
profitability indexes of 1.17

RATE OF RETURN 10%

NET CASH FLOW
END OF YEAR PVIF 10% PV
PROJECT D
0 -1200
1 1000 0.9 909.1
2 500 0.8 413.2
3 100 0.8 75.1 1397.45
NPV Project D 197.45
PI Project D 1.165

NET CASH FLOW

END OF YEAR PVIF 10% PV
PROJECT I
0 -1200
1 100 0.9091 90.91
2 600 0.8264 495.87
3 1080 0.7513 811.42 1398.20
NPV Project I 198.20
PI Project I 1.165
 ernal rates of return for projects D and I are 23% and 17%,
pectively. For every discount rate greater than 10 percent, project D’s
t present value and profitability index will be larger than those for
oject I. On the other hand, for every discount rate less than 10
rcent, project I’s net present value and profitability index will be larger
an those for project D. If we assume a required rate of return (k) of 10
rcent, each project will have identical net present values of $198 and
ofitability indexes of 1.17
 NET CASH FLOW
END OF YEAR
PROJECT X PROJECT Y Internal rates of return for projects X and Y are 50
0 (1,000) (1,000) percent and 100 percent, respectively. If the requi
1 - 2,000 rate of return is 10 percent, the net present value
project X is $1,536, and its profitability index is 2.5
2 - - project Y the net present value is $818 with a
3 3,375 - corresponding profitability index of 1.82
IRR 50% 100%

RATE OF RETURN 10%

NET CASH FLOW
END OF YEAR PV
PROJECT X
0 (1,000)
1 - -
2 - -
3 3,375 2,536
NPV Project X 1,536
PI Project X 2.54

NET CASH FLOW

END OF YEAR PV
PROJECT Y
0 (1,000)
1 2,000 1,818
2 - -
3 - -
NPV Project Y 818
PI Project Y 1.82
urn for projects X and Y are 50
rcent, respectively. If the required
percent, the net present value of
and its profitability index is 2.54. For
esent value is $818 with a
tability index of 1.82
 INITIAL CASH
PROJECT IRR NPV PI
OUTFLOW
A 50,000 15% 12,000 1.24 If the budget ceiling fo
B 35,000 19% 15,000 1.43 the present period is
independent of each
C 30,000 28% 42,000 2.4 select the combinatio
D 25,000 26% 1,000 1.04 the greatest increase
E 15,000 20% 10,000 1.67 less) can provide. Sele
order of profitability a
F 10,000 37% 11,000 2.1 discounted cash flow
G 10,000 25% 13,000 2.3 budget is exhausted r
H 1,000 18% 100 1.1

INITIAL
PROJECT IRR NPV
OUTFLOW
F 37% 11,000 10,000 With capital rationing
C 28% 42,000 30,000 E, F, and G, totaling $6
other mix of available
D 26% 1,000 25,000 total net present valu
54,000 65,000 projects provide. Beca
you cannot necessaril
increase the net prese
INITIAL invest in an acceptabl
PROJECT IRR NPV OUTFLOW constraint allows such
C 28% 42,000 30,000
B 19% 15,000 35,000
57,000 65,000

PROJECT PI NPV INITIAL

OUTFLOW
C 2.4 42,000 30,000
G 2.3 13,000 10,000
F 2.1 11,000 10,000
E 1.67 10,000 15,000
76,000 65,000
If the budget ceiling for initial cash outflows during
the present period is $65,000 and the proposals are
independent of each other, you would want to
select the combination of proposals that provides
the greatest increase in firm value that $65,000 (or
less) can provide. Selecting projects in descending
order of profitability according to the various
discounted cash flow methods until the $65,000
budget is exhausted reveals the following:

With capital rationing, you would accept projects C,

E, F, and G, totaling $65,000 in initial outflows. No
other mix of available projects will provide a greater
total net present value than the $76,000 that these
projects provide. Because of the budget constraint,
you cannot necessarily invest in all proposals that
increase the net present value of the firm; you
invest in an acceptable proposal only if the budget
constraint allows such an investment
 r n PVIFA
15.00% 10 5.019
15.00% 4 2.855
2.164

r n PVIFA
14.00% 10 5.216
14.00% 4 2.914
2.302

r n PVIFA
13.00% 10 5.426
13.00% 4 2.974
2.452
1. A PRESENT VALUE DISC
YEAR CASH FLOW
FACTOR (15%)
0 (700,000) 1
1 (1,000,000) 0.870
2 250,000 0.756
3 300,000 0.658
4 350,000 0.572
5 s/d 10 400,000 2.164
NPV

B 14% DISCOUNT
YEAR CASH FLOW
FACTOR
0 -700000 1.000
1 -1000000 0.877
2 250,000 0.769
3 300,000 0.675
4 350,000 0.592
5 s/d 10 400,000 2.302
NPV

1%

13% IRR 14%

14,000 - (54,250)

14,000

68,250

X = 14,000
1% 68,250

X = 0.0021

C The project would be acceptable.

D Payback period = 6 years. (−$700,000 − $1,000,000 + $250,000 + $300,000 + $350,000 + $4
 PRESENT VALUE

(700,000)
(870,000)
189,000
197,400
200,200
865,600
(117,800)

13% DISCOUNT 13% PRESENT

14% PRESENT VALUE
FACTOR VALUE
(700,000) 1.0000000 (700,000.00)
(877,000) 0.8849558 (884,956)
192,250 0.7831467 195,750.00
202,500 0.6930502 207,900.00
207,200 0.6133187 214,550.00
920,800 2.4517722 980,800.00
(54,250) 14,044

0 + $250,000 + $300,000 + $350,000 + $400,000 + $400,000 = 0)

YEAR
0
1
2
3
4
5
6
7
8
 PRESENT VALUE DISCOUNT
CASH FLOW FACTOR (14%) PRESENT VALUE
(404,424) 1 (404,424)
86,890 0.877 76,203
106,474 0.769 81,879
91,612 0.675 61,838
84,801 0.592 50,202
84,801 0.519 44,012
75,400 0.456 34,382
66,000 0.400 26,400
92,400 0.351 32,432
NPV 2,924
 INVESTMENT PRESENT VALUE OF FUTURE NET PRESENT
PROJECT S
REQUIRED CASH FLOWS VALUE
1 200,000 290,000 90,000
2 115,000 185,000 70,000
3 270,000 400,000 130,000
1, 2 315,000 475,000 160,000
1, 3 440,000 690,000 250,000
2, 3 385,000 620,000 235,000
1, 2, 3 680,000 910,000 230,000