The payback period is time required to recover the initial
investment in a project.
Time taken for A for net cash flows to equal 500 = 200*1 + 100*3,
therefore payback period is 4years
Time taken for B for net cash flows to equal 400 = 200*1 + 125*1 +
125 *3/5, therefore payback period is 2(3/5)years
Time taken for C for net cash flows to equal 300 = 200*1 + 100*1,
therefore payback period is 2years
Based on payback period, project C will be chosen as it has the
lowest payback.
To calculate benefit cost ratio, the net present value of costs and benefits is calculated and then the ratio is computed
A | B | C | |
Initial cost | -500 | -400 | -300 |
1st year benefit | 200 | 200 | 200 |
Subsequent annual benefit | 100 | 125 | 100 |
Life | 8 | 8 | 8 |
Discounted Benefits in first year | 200+PV(0.1,7,100) | 200+PV(0.1,7,125) | 200+PV(0.1,7,100) |
$686.84 | $808.55 | $686.84 | |
PV of benefits | Benefits in first year/(1.1) | ||
$624.40 | $735.05 | $624.40 | |
B/C | 1.25 | 1.84 | 2.08 |
We choose the project with highest B/C, hence project C is chosen
For incremental benefit cost analysis, we start with the base project with the least cost, in this case project C, we compute the present value of additional benefits and costs of moving to any other project. In this case, only project B has some additional cash flows!
Incremental cash flow | 25 |
Benefits in first year | $121.71 |
PV Benefits | $110.65 |
Can also be computed by 735.05-624.40 | |
Incremental cost | 100 |
Incremental B/C | 1.11 |
Since the ratio is more than 1, we choose project B. There are
no incremental cash-flows while moving from B to A, hence B is
chosen!
Cash flow diagrams
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