NET PRESENT VALUE,

RATE OF RETURN,
AYBACK PERIOD & BENEFIT COST
RATIO
PREPARED BY: ENGR. OWEN FRANCIS A. MAONGAT
ES 123 INSTRUCTOR
 OBJECTIVES:

• To determine the net present value, rate of return, payback

period, benefit-cost ratio.
 1- NET PRESENT VALUE
• The definition, PRESENT WORTH formula, for the NPV is repeated here:

(8.1)

• in which the notation emphasizes our assumption that the initial cash flow, CFo, is negative (a capital outlay). No
assumption is made concerning the signs of the remaining CFj, although often these terms will all be positive
(revenues). In the special case CFj = A (j = 1,2, . . . , n), (8.1) becomes, in view of

(8.2)
• as it must. Another name for the NPV is the discounted cash DCF. From (8.1) it is seen that the NPV is positive when
and only when the total value of the returns CF, (in year 0 dollars) exceeds the amount invested, (year 0 dollars); that is
to say, when and only when the original amount, earning compound interest at rate i for n years, would be insufficient
to generate the returns. For a proposed investment to be economically acceptable, the NPV must be positive or, at
worst, zero (in which case the investment of would just suffice to yield the revenues CFj).
• Example 8.1 The cash flows associated with a milling machine are CFo= - $50,000.
CFj = $15000 (j = 1,2,3,4,5). Determine the economic acceptability of this machine at
interest rates of (a) 10%, (b) 15%, and (c) 20% per year, all compounded annually.

• The machine is seen to be an economically acceptable investment when the interest rate is
10%, and (barely) when the interest rate is 15%. It is not economically justifiable to buy
the machine if the interest rate is 20%.
 2 - RATE OF RETURN
• The rate of return (ROR) for a series of cash flows is that particular value, i*,
of the interest rate for which the NPV vanishes. Thus, if we plot the NPV as a
function of i, using (8.1) or (8.2), the curve will cross the i-axis at i*.
Alternatively, we could find, by trial and error, i-values for which the NPV is
slightly positive and slightly negative, and interpolate linearly between them
for i*. If a more accurate approximation for i* is required, the Newton-
Raphson iteration method or another numerical technique can be used to solve
(8.1) or (8.2) for i, with the left side replaced by zero.
Example 8.2 Find the ROR for the machine of Example 8.1.
By linear interpolation between the results of Example 8. l(b) and (c):

Case of a Single Sign-Reversal

From Previous Chapter, first section, we know that when CFo < 0 and CFj > 0 (j > 0) - that is, when
there is just one reversal of sign in the sequence CFo, CF1, CF2, . . . , CF, -the NPV is a monotone
decreasing function of i, and so i* is uniquely determined.
Case of Multiple Sign-Reversals
When the sequence CFo, CF1, CF2,. . . , CFn, shows more than one reversal of sign, it is possible
that NPV = 0 for several values of the interest rate; there could thus be several rates of return.
• Example 8.3 For the series of cash flows

• Determine the NPV at annual interest rates 0%, 5%, 10%, 20%, 30%, 50%, and 70%. From a graph of the
results, find the rate(s) of return. For the given flows,

• and evaluation at the specified interest rates gives the points

• which are plotted in Fig. 8-1. It is seen that there are two rates of return in this case, i* - 7% and i* = 5%.
 3 - PAYBACK PERIOD

• The payback period (PBP) is the time required for an initial investment to be recovered, neglecting the
time value of money. Thus, if | CFo | represents the initial investment and CFj is the net cash inflow for the
jth year (j = 1,2,3,4, . , n), the payback period satisfies

• If the yearly cash inflows are equal, or if an average value is used, then it simplifies to

• where YCF represents the (average) yearly cash inflow.

• Example 8.5 Determine the payback period for a proposed investment as follows:

• The sum of the first three yearly cash inflows, $37 000, is less than the initial investment, $50 000; but
the sum of the first four yearly cash inflows, $55 000, exceeds the initial investment. Hence the payback
period will be somewhere between 3 and 4 years. Linear interpolation yields

• Because it ignores the time value of money, the payback method should not be used in place of the other
methods discussed above. On the other hand, the payback method is valuable for a secondary analysis,
when the NPV or ROR is used as the primary method. As will be further discussed in Next Chapter
(Choose Among Alternatives), there are many practical examples where an investment is sought with a
high rate of return and a sufficiently short payback period.
• Example 8.6 Determine the payback period and the net present value for each proposal in
Table 8-1, using an interest rate of 10°/o per year, compounded annually. Which proposal is
best?

• Proposals A and B each have a 3 year payback period; however, proposal A has an NPV of
$4248, while proposal B has an NPV of $10 289. Proposal C has an NPV of $13 792, but it has
a 3.58-year payback period (assuming the $130 000 to be evenly spread over the fourth year).
 In summary:

• Since proposal A is inferior to proposal B, it can be eliminated from further

consideration. Proposal C is economically superior to proposal B, but its longer
payback period might constrain the decision maker to choose proposal B instead (e.g.,
if the firm were cash-poor and could not afford to wait until the end of the third year to
receive any cash inflows). Thus, the choice of the best investment alternative may
involve a trade-off among two or more objectives, with the PBP providing important
secondary information.
 4 - BENEFIT-COST RATIO

• The benefit-cost ratio (BCR) is often used to assess the value of a municipal
(8.6)
project in relation to its cost; it is defined as

(8.7)
• where B represents the equivalent value of the benefits associated with the
project, D represents the equivalent value of the disbenefits, and C represents
the project's net cost. Similarly, the net benefit value (NBV) is defined as
 4 - BENEFIT-COST RATIO

• For a project to be desirable, BCR > 1 or NBV>O. This rule must be applied
with caution, however, since benefit quantification is usually not very precise
and since the distinction between disbenefits and costs is somewhat
conjectural. The BCR may vary considerably depending on whether the
disbenefits are included in the numerator, or are classified as(8.7)a cost and
included in the denominator. If questions arise about the classification of
disbenefits, it is better to use the NBV approach, because NBV = B – D - C
gives the same value irrespective of how the disbenefits are
classified. Either present worth (the NPV), future worth, or the EUAS
approach may be used to evaluate B, D, and C, provided the same method be
used for all three terms.
• Example 8.7 A large city is located close to a major seaport. It has been proposed
that a new superhighway be built between the city and the seaport, running parallel
to the present congested, two-lane highway. A group of consulting engineers has
estimated that the new highway will provide the following direct benefits: (1)
additional commerce between the city and the seaport, having a value of $50 million
per year; (2) future economic growth within the region over a 10-year period,
resulting in an increase of $5 million per year in commercial activity, beginning in
the second year; (3) a reduction in highway accidents, resulting in a direct savings
of approximately $0.8 million per year. On the other hand, the following
disadvantages or disbenefits are associated with the new highway: (i) the
destruction of valuable farmland that currently contributes $1.3 million per year to
the regional economy; (ii) a decrease in commercial activity along the present
highway, resulting in a loss of $0.7 million per year. Assess the desirability of the
proposed superhighway, based on a construction cost of $280 million and a yearly
maintenance cost of $1.5 million. Assume a lifetime of 30 years and an interest rate
of 7%, compounded annually.
• Example 8.7

• GIVEN:
• (1) additional commerce between the city and the seaport, having a value of $50 million per year;
• (2) future economic growth within the region over a 10-year period, resulting in an increase of $5 million
per year in commercial activity, beginning in the second year;
• (3) a reduction in highway accidents, resulting in a direct savings of approximately $0.8 million per year.
• On the other hand, the following disadvantages or disbenefits are associated with the new highway:
• (i) the destruction of valuable farmland that currently contributes $1.3 million per year to the regional
economy;
• (ii) a decrease in commercial activity along the present highway, resulting in a loss of $0.7 million per
year.

• Assess the desirability of the proposed superhighway, based on a construction cost of $280 million and a
yearly maintenance cost of $1.5 million. Assume a lifetime of 30 years and an interest rate of 7%,
compounded annually.
Over the entire 30-year period, the yearly net benefits, B - D, are given by the EUAS
method as

B - D = $50 + $5(A/G, 7%, 10)(P/A, 7%,10)(A/P, 7%, 30) + $0.8 - ($1.3 +

$0.7)
= $60.0 million
• Similarly, the yearly costs are given by
C = $280(A/P, 7%, 30) + $1.5 =
$24.1 million
and the benefit-cost ratio is

Since BCR >1, the proposed highway is considered to be desirable.