Extended Example: Cash Flows for Lily Company Machine

J: Let’s sink our teeth into a more complex NPV and IRR analysis.

K: Absolutely. Let’s include working capital and income taxes and depreciation and …

J: Hold on there, Chief. Not so fast. Let’s start with a basic example, then build it up to include the things you mentioned.

K: Good call. Alright, Lily Company is considering purchasing a machine. The associated cash inflows and outflows are as follows:

J: Cost of the machine is $100,000.

K: Cash revenues from the output from the machine are expected to be $70,000 per year for 5 years.

J: Cash expenses are expected to be $30,000 per year for 5 years.

K: At the end of 5 years, the machine is expected to have a salvage value of $10,000.

J: The required rate of return on this project is 10%.

K: All cash flows occur at the end of the appropriate year, except for the $100,000 initial cost.

J: We are going to use these numbers to compute the NPV and the IRR of the Lily Company machine.

K: But first, let discuss a simple capital budgeting tool called “payback period.” This tool involves computing how many years it will take to recover the initial investment cost.

J: The payback period is just the time it takes for the company to recover its original investment, calculated by dividing the original investment by the net annual cash flows received from the investment.

K: In the case of the machine purchase being considered by Lily Company, the payback period is 2.5 years, computed as follows:

                                  Initial Investment                             $100,000                

Payback Period   =      -------------------            =             -----------------            =        2.5 years

                             Net Annual Cash Inflow                         $40,000                 

J: In this example, the Net Annual Cash Inflow of $40,000 is computed as the $70,000 annual cash revenues minus the $30,000 annual cash expenses.

K: One way to use this payback period number is to invest only in assets that pay back within a certain period of time, perhaps five or six years.

J: The required payback period might be set differently for different types of assets.

K: For example, a payback period of 2.5 years for the purchase of a building seems like a very good investment indeed. We expect a building to last a lot longer than 2.5 years.

J: On the other hand, a 2.5-year payback period for an investment in a computer system upgrade seems a little less attractive. It isn’t unusual for computer and technology needs to change dramatically in 2.5 years, or less.

K: I’ve got a personal example.

J: Go for it.

K: A couple of years ago a solar panel salesperson visited with my wife Ramona.

J: You’re thinking of getting solar panels?

K: Yeah, a little bit. Ramona really likes the idea. So she had this salesperson come to our house.

J: How does payback period fit into this?

K: Well, that was the salesperson’s sales pitch. He showed Ramona a bunch of numbers about installation costs and electricity cost savings and so forth, and then boiled everything down into one number: How long would it take for the solar panels to pay for themselves?

J: Exactly. The payback period. So, what is the number? How long is the payback period?

K: According to this salesperson, for our house the solar panel payback period is 15 years.

J: Installing solar panels is a good example of a long-term project that requires careful capital budgeting analysis. And payback period is simple way to do this.

K: Of course, payback period analysis doesn’t specifically incorporate the time value, but it is certainly one way to think about a long-term project.

J: So, did you buy the solar panels?

K: No. Ramona thought that the 15-year payback period was a little too long. Plus she was not convinced about the reliability of the salesperson’s calculations. But she’s still looking around …

J: The simple payback period for the machine being considered by Lily Company is 2.5 years. That seems pretty fast.

K: Let’s do the full NPV and IRR analyses to see whether they confirm that this machine looks like a good project.