2/26/2015

GE Unveils $6 Billion HealthUnit Plan:

Goal: Increase the market
share in the healthcare
sector.
Strategies: Develop products
that will lower costs, increase
access and improve healthcare quality.

Investment required: $6
billion over six years
Desired project outcome:
Would help GEs health-care
unit grow at least twice as fast
as the broader economy.

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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?

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 payback period, the project
would be considered for further analysis.

Weakness:
Does not consider the time value of money

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Example 1
Pizza-in-a-Hurry operates a pizza delivery, they use,
two eight year-old vehicles for delivery, both of which
are large, consume a great deal of gas and are starting
to cost a lot to repair. The owner, Ray, is thinking of
replacing one of the cars with a smaller, three-year-old
car that his sister-in-law is selling for $8000. Ray
figures he can
save $3000, $2000, and $1500 per year for the next
three years and $1000 per year for the following two
years by purchasing the smaller car. What is the payback
period for this decision?

The cash flows for two alternatives are as follows:

year

-$1000

-$2783

+200

+1200

+200

+1200

+1200

+1200

+1200

+1200

+1200

+1200

+1200

+1200

Find the Pay Back Period

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Annual cash flow

$1200
$200

$200

$1200 $1200 $1200

0
3

Years

Cumulative cash flow ($)

$1000

2.5 years
Payback period

1500
1000
500
0
-500
-1000
0

6
Years (n)

How long does it take to recover the initial

investment for Project B in Example 2?

2/26/2015

A firm is trying to decide which of two weighing

scales it should install to check a package-filling
operation in the plant. If both scales have a 6-year
life, which one should be selected? Assume an
8% interest rate.
Alternative

Cost ($)

Uniform Annual
Benefit
($)

End of useful Life

(salvage Value) ($)

Atlas Scale

2000

450

100

Tom Thumb

3000

600

700

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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 payback period,
the project would be considered for further
analysis.

Weakness:
Cash flows occurring after DPP are ignored

Autonumerics company has just bought a new

spindle machine at a cost of $105,000 to
replace one that had a salvage value of 20,000.
the projected annual after-tax savings via
improved efficiency, which will exceed the
investment cost, are as follows:

What is the Discounted Pay back Period ?

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$45,000

$35,000

$45,000

Annual cash flow

$25,000

$35,000

$15,000

0
1

Years
$85,000

Discounted Payback Period Calculation

Period

Cash Flow

-$85,000

Cost of Funds
(15%)*

Cumulative
Cash Flow

-$85,000

15,000

-$85,000(0.15) = -$12,750

-82,750

25,000

-$82,750(0.15) = -12,413

-70,163

35,000

-$70,163(0.15) = -10,524

-45,687

45,000

-$45,687(0.15) =-6,853

-7,540

45,000

-$7,540(0.15) = -1,131

36,329

35,000

$36,329(0.15) = 5,449

76,778

* Cost of funds = (Unrecovered beginning balance) X (interest rate)

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Two equivalent pieces of quality inspection

equipment are being considered for purchase by
Square D Electric. Machine 2 expected to be
versatile and technologically advanced enough
to provide net income longer than machine 1.
Assume i= 15%.
Machine 1

Machine 2

First cost($)

12,000

8,000

Annual NCF($)

3,000

1,000(years 1-5)
3,000(years 6-14)

Maximum life (years)

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Principle: Compute the equivalent net surplus at n = 0 for a given

interest rate of i.

Decision Rule for Single Project Evaluation: Accept the project if the
net surplus is positive.

Decision Rule for Comparing Multiple Alternatives: Select the
alternative with the largest net present worth.

Inflow
0

1
2

Outflow
PW(i)inflow

5
Net surplus
PW(i) > 0

PW(i)outflow

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inflow
$24,400
0
1

$55,760

$27,340
2

outflow
$75,000

An electrical motor rated at 15HP needs to be

purchased for $1,000.
The service life of the motor is known to be 10
years with negligible salvage value.
Its full load efficiency is 85%.
The cost of energy is $0.08 per kwh.
The intended use of the motor is 4,000 hours
per year.
Find the total cost of owning and operating the
motor at 10% interest.

10

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10

$1,000
$4,211

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2/26/2015

NFW is based on the equivalent worth of all cash inflows and outflows at the
end of the study period at an interest rate that is generally the MARR.

Given: Cash flows and MARR (i)

Find: The net equivalent worth at a
specified period other than
present, commonly the end of
project life
Decision Rule: Accept the project if
the equivalent worth is positive.
$24,400
0
1

$55,760

$27,340
2

$75,000

Project life

A $45,000 investment in a new conveyor

system is projected to improve throughput and
increasing revenue by $14,000 per year for five
years. The conveyor will have an estimated
market value of $4,000 at the end of five years.
Using FW and a MARR of 12%, is this a good
investment?

12

2/26/2015

NFW = -$45,000(F/P, 12%, 5)+$14,000(F/A, 12%, 5)+$4,000

NFW = -$45,000(1.7623)+$14,000(6.3528)+$4,000

NFW = $13,635.70 >0.0

Higgins Corporation (HC) has developed a robot called Helpmate

The firm would need a new plant for manufacturing.
Plant could be built and would be ready for production in 2 years
12 hectares site is needed (could be purchased with a cost of 1.5
million in year 0 )
Building construction would begin early in year 1 and continue
throughout year 2
Building cost  10 million (4 million at the end of year 1 and 6 million
at the end of year 2)
Manufacturing equipment  13 million at the end of year 2
After termination land after tax worth 2 million , building 3 million
and equipment 3 million
The plant would begin operation at the beginning of year 3, first cash
flow at the end of year 3 and economic life is 6 years
i = 15%

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2/26/2015

Barcewell, built a hydroelectric plant using his personal savings

of $800,000
Power generating capacity of 6 million kwhs
Estimated annual power sales after taxes - $120,000
Expected service life of 50 years
Was Bracewell's $800,000 investment a wise one?
How long does he have to wait to recover his initial investment,
and will he ever make a profit?

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Capitalized worth is a special case of the present worth, it is the

present worth of all revenues or expenses over an infinite
project life time.
Capitalized cost Expenses only

Principle: PW for a project with an annual receipt of A over
infinite service life
Equation:
CE(i) = A(P/A, i,
) = A/i

A
0
P = CE(i)

Given: i = 10%, N =
Find: P or CE (10%)

$2,000
$1,000
0

10

P = CE (10%) = ?

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2/26/2015

$2,000
$1,000
0

10

P = CE (10%) = ?

Construction cost = $2,000,000

Annual Maintenance cost = $50,000

Renovation cost = $500,000 every 15 years

Planning horizon = infinite period

Interest rate = 5%

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2/26/2015

Years
15

30

45

60

$500,000

$500,000

$500,000

$500,000

0
$50,000

$2,000,000

Solution:

Construction Cost
P1 = $2,000,000

Maintenance Costs
P2 = $50,000/0.05 = $1,000,000

Renovation Costs
P3 = $500,000(P/F, 5%, 15)
+ $500,000(P/F, 5%, 30)
+ $500,000(P/F, 5%, 45)
+ $500,000(P/F, 5%, 60)
.
= {$500,000(A/F, 5%, 15)}/0.05
= $463,423

Total Present Worth
P = P1 + P2 + P3 = $3,463,423

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Concept: Find the effective interest rate per payment period

0

15

$500,000

30

$500,000

45

60

$500,000 $500,000

Effective interest rate for a 15-year cycle

i = (1 + 0.05)15 - 1 = 107.893%

Capitalized equivalent worth
P3 = $500,000/1.07893
= $463,423

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