YEAR PROJECT A PROJECT B
0 -$100,000 -$100,000
1 32,000 0
2 32,000 0
3 32,000 0
5 32,000 $200,000
The required rate of return on these projects is 11 percent.
Project A: Net present value is found by taking the original investment cost, $100,000 (that would be a negative amount since it's cash out the door), and then adding the present value of the annual cash inflows expected ($32,000 for 5 years at the required rate of return of 11%). You look up in the present value annuity table the factor for 5 years at 11%, which is 3.696, and multiply by 32,000 to get present value of expected cash inflows = $118,272. Net present value = $118,272 - $100,000 = $18,272 Payback period is the time that it takes a project to recover its initial cost from the revenue it generates. Payback period = Investment required / Net annual cash inflow = $100,000 / $32,000 = 3.125 years.
Project B: In this one, there are no annual cash inflows, just the one inflow of $200,000 in year 5. So you need to find the present value of $200,000 five years from now at 11%. You don't use the annuity table for this one, you use the present value of $1 table. The factor this table gives is 0.593. So the present value of $200,000 five years from now at 11% is $200,000 * 0.593 = $118,600. Net present value = $118,600 - $100,000 = $18,600 The payback period for this project is five years. It's not until the cash inflow of $200,000 in year 5 that the project recovers its original cost.