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an INVESTMENT by the discounted sum of all cash flows received from the project. The

formula for the discounted sum of all cash flows can be rewritten as

calculate an estimate of how profitable the project or INVESTMENT will be. In theformula,

the -C0 is the initial investment, which is a negative cash flow showing thatmoney is going

out as opposed to coming in. Considering that the money going out is subtracted from the

discounted sum of cash flows coming in, the net present value would need to be positive in

order to be considered a valuable investment.

To provide an example of Net Present Value, consider company Shoes For You's who is

determining whether they should INVEST in a new project. Shoes for You's will expect to

invest $500,000 for the development of their new product. The company estimates that the

first year cash flow will be $200,000, the second year cash flow will be $300,000, and the

third year cash flow to be $200,000. The expected return of 10% is used as the discount

rate.

The following table provides each year's cash flow and the present value of each cash flow.

Year

0

1

2

3

Cash Flow

-$500,000

$200,000

$300,000

$200,000

Present Value

-$500,000

$181,818.18

$247,933.88

$150,262.96

The net present value of this example can be shown in the formula

When solving for the NPV of the formula, this new project would be estimated to be a

valuable venture.

Payback Period

The payback period formula is used to determine the length of time it will take to recoup the

initial amount INVESTED on a project or investment. The payback period formula is used

for quick calculations and is generally not considered an end-all for evaluating whether to

invest in a particular situation.

The result of the payback period formula will match how often the cash flows are received.

An example would be an initial outflow of $5,000 with $1,000 cash inflows per month. This

would result in a 5 month payback period. If the cash inflows were paid annually, then the

result would be 5 years.

At times, the cash flows will not be equal to one another. If $10,000 is the

initial INVESTMENT and the cash flows are $1,000 at year one, $6,000 at year two,

$3,000 at year three, and $5,000 at year four, the payback period would be three years as

the first three years are equal to the initial outflow.

There are a few drawbacks to the payback period formula that may warrant one to consider

using another method of determining whether to INVEST .

One issue is that the payback period formula does not look at the value of all returns.

Suppose a situation where there are two choices to choose from where INVESTMENT X

has a payback period of 1 year and INVESTMENT Y has a payback period of 2 years.

However, investment X will only return the initial investment whereas investment Y will

eventually pay double the initial investment. Given the additional information not provided

by the payback period formula, one may consider investment Y to be preferable. The

formula for the net present value method may be used to close this information gap in order

to properly evaluate the best choice.

However, it is worth mentioning that although the net present value method may be

preferable to determine long term profitability, the payback period formula helps with cash

flow analysis for short term budgeting. Suppose a situation where investment X has a net

present value of 10% more than its initial investment and investment Y has a net present

value of triple its initial investment. At first glance, investment Y may seem the reasonable

choice, but suppose that the payback period for investment X is 1 year and investment Y is

10 years. Investment Y could cause problems if the investment is needed sooner. An

analogy of this would be like banks where maintaining cash flows of their

investments(loans) is vital to their business.

Another issue with the formula for period payback is that it does not factor in the time value

of MONEY . The time value of money concept, as it applies to the payback period formula,

proposes that each future cash flow is worth less when compared to today's value. The

discounted payback period formula may be used instead to consider the time value of

money, however the discounted payback period formula takes away the benefit of making

quick calculations.

The present value of annuity formula determines the value of a series of future periodic

payments at a given time. The present value of annuity formula relies on the concept of

time value of money, in that one dollar present day is worth more than that same dollar at

a future date.

As with any FINANCIAL formula that involves a rate, it is important to make sure that the

rate is consistent with the other variables in the formula. If the payment is per month, then

the rate needs to be per month, and similarly, the rate would need to be the annual rate if

the payment is annual.

An example would be an annuity that has a 12% annual rate and payments are made

monthly. The monthly rate of 1% would need to be used in the formula.

Assumptions

The formula shown has assumptions, in that it must be an ordinary annuity. These

assumptions are that

1) The periodic payment does not change

2) The rate does not change

3) The first payment is one period away

If the payment and/or rate changes, the calculation of the present value would need to be

adjusted depending on the specifics. If the payment increases at a specific rate, the present

value of a growing annuity formula would be used.

If the first payment is not one period away, as the 3rd assumption requires, the present

value of annuity due or present value of deferred annuity may be used. An annuity due is an

annuity that's initial payment is at the beginning of the annuity as opposed to one period

away. A deferred annuity pays the initial payment at a later time.

The present value of a series of payments, whether the payments are the same or not, is

When the periodic payments or dividends are all the same, this is considered a geometric

series. By using the geometric series formula, the formula can be rewritten as

Notice that (1+r) is canceled out throughout the equation by doing this. The formula is now

reduced to

The P's in the numerator can be factored out of the fraction and become 1. The 1's in the

denominator of the formula are subtracted from one another. After making these

adjustments, the formula is simplified to the present value of annuity formula shown on the

top of the page.

The equivalent annual annuity formula is used in capital budgeting to show the net present

value of an INVESTMENT as a series of equal cash flows for the length of the INVESTMENT

. The net present value(NPV) formula shows the present value of an investment that has

uneven cash flows. When comparing two different INVESTMENTS using the net present

value method, the length of the investment (n) is not taken into consideration. An

investment with a 15 year term may show a higher NPV than an investment with a 4 year

term. By showing the NPV as a series of cash flows, the equivalent annual annuity formula

provides a way to factor in the length of an investment.

An example of how the equivalent annual annuity formula may be useful is comparing

twonew projects where one project has a 15 year term and the other has a 4 year term.

Assume that both projects have the same NPV. The 4 year project will receive

the returnsooner so it will show a higher cash flow when using the equivalent annual

annuity formula. In real life, comparing two INVESTMENTS will not always be so obvious

and the formula should be applied.

Another way of explaining the usefulness of the equivalent annual annuity formula is that

an INVESTMENT with a shorter life span can be reinvested and the earnings on the

reinvestment is not taken into consideration when using the NPV formula. The equivalent

annual annuity formula provides a comparison relative to time which eliminates the need for

considering reinvestment with the same earnings as the current investment.

The equivalent annual annuity formula uses the annuity payment formula for when present

value is given. Net present value replaces present value to give relevance to the use of the

equivalent annual annuity formula.

Using the prior example of comparing one project with a 4 year term and another project

with a 15 year term, the NPV of the 4 year project is $100,000 and the NPV of the 15 year

project is $150,000. The rate used for both is 8%. Putting the variables of the 4 year

project in the equivalent annual annuity formula shows

Putting the variables of the 15 year project into the equivalent annual annuity formula

shows

Comparing these two projects, the 4 year project will return a higher amount relative to the

time of the INVESTMENT . Although the 15 year project has a higher NPV, the 4 year

project can be reinvested and have additional earnings for the 11 years that remain on the

15 year project.

**See below for simple and uneven cash flows version

The discounted payback period formula is used to calculate the length of time to recoup

anINVESTMENT based on the INVESTMENT'S discounted cash flows. By discounting each

individual cash flow, the discounted payback period formula takes into consideration the

time value of money.

The discounted payback period formula is used in capital budgeting to compare a project or

projects against the cost of the investment. The simple payback period formula can be used

as a quick measurement, however discounting each cash flow can provide a moreaccurate

picture of the investment. As a simple example, suppose that an initial cost of a project is

$5000 and each cash flow is $1,000 per year. The simple payback period formula would be

5 years, the initial investment divided by the cash flow each period. However, the

discounted payback period would look at each of those $1,000 cash flows based on its

present value. Assuming the rate is 10%, the present value of the first cash flow would be

$909.09, which is $1,000 divided 1+r. Each individual cash flow would then be discounted

to its present value until it is determined how long it would take to recoup the original

$5,000.

Using the prior example of a project that costs $5,000 with $1,000 annual cash flows.

Assuming the company uses a discount rate of 10%, the discounted payback period for this

example would be calculated based on the following equation:

which results in a discounted payback period of 7.273. Although this formula calculates

results with decimals, it is important to consider that there may be a slight difference due to

rounding and more importantly, that there may not be a such thing as a partial cash inflow.

This may warrant rounding up to determine how long it would take to recoup the

initial INVESTMENT .

The formula listed at the top of the page assumes that each cash flow is equal. In many

cases, the cash flows will not be equal. The simple version of the discounted payback period

formula is:

This is not as much a formula, as a way of explaining that the discounted cash flow method

discounts each inflow until net present value equals zero.

Another method to simplify the calculation when cash flows are even is to use a table for

the present value of annuity factor in order to solve n. The need to solve for n in the present

value of annuity formula will be further explained in the following section.

The formula shown at the top of the page assumes that all cash flows are equal. If all cash

flows are equal, then the INVESTMENT return is simply an annuity. The point of the

discounted payback period formula is to calculate how long before the present value equals

the initial investment(NPV = 0). Thus, since PV of the annuity equals the initial investment,

solving for n, the number of periods, based on the present value of annuity formula can be

used. The only difference between solving for n based on the PV of annuity formula and the

formula shown at the top of the page is substituting PV for the initial investment since they

are both equal.

As stated in the prior section, the process of calculating the discounted payback period

when all cash flows are equal could be simplified by using a present value of annuity table

to calculate n.

If the cash flows are uneven, then the longer method of discounting each cash flow would

be used.

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