Step 3 - Establish the timing of the costs/benefits.
Step 4 - Calculate net present value of each alternative.
Step 5 - Select the offer with the best net present value.
Example:- .
Lester company has an investment opportunity with an economic life of 5 years. Salvage value of equipment is estimated at $5,000. At the end of five years, the working capital will be released. Lester uses a discount rate of 10%. The following costs and revenues are estimated.
Cost of capital equipment $160,000.
Working capital required 100,000.
Relining equipment in 3 years 30,000.
Annual sales revenue 750,000.
Annual cost of sales 400,000.
Annual operating expenses 270,000.
Cash 10% Present.
Year Flows Factor Value.
Investment 0 $(160,000) 1.00 $(160,000).
WC needed 0 (100,000) 1.00 (100,000).
Annual net cash 1-5 80,000 3.79 303,200.
Relining of equip. 3 (30,000) 0.75 (22,500).
Salvage value 5 5,000 0.62 3,100.
WC released 5 100,000 0.62 62,000.
Net present value $85,800.
b) Payback method.
In its simple form, payback period method finds the number of years of cash inflows needed to cover the cost of the project. The decision rule is to accept a project if its payback period is substantially less than its economic life (or its payback period is less than the alternatives). The discounted payback method finds the number of years required for the discounted cash inflows to cover the cost of the project. Based on the payback rule, an investment is acceptable if its calculated payback period is less than some pre-specified number of years. .
Advantages of payback method:.
• It is a good screening device -- If a project does not provide a payback within some specified period, then cash considerations, and the risk due to changing technology, prevent its acceptance.
