University of Miami Payback Periods Discussion

– No word count responds to each separately.

Respond: Payback is the number of years that it takes to recover the cost of investment.” (Reiter and Song, 2018, p.253). I find this interesting because when I think of payback, I just think of the amount of money that has to be paid back to the lender. I never thought about the calculation of the number of years. The example the book gives is great because it really breaks down how the number of years is calculated. “For example, assume that an EKG (electrocardiogram) machine that costs $2,500 is expected to net $1,000 in cash flow in each of the next five years. If things go as expected, the $2,500 investment will be recovered in three years” (Reiter and Song, 2018, p.253) When this happens the this will cut down the payback time. The book explains that the shorter the payback the better.

Net present value (NPV) is simply the sum of the present values of all the project’s net cash flows when discounted at the project’s opportunity cost of capital, measures a project’s expected dollar profitability. An NPV greater than zero indicates that the project is expected to be profitable after all costs, including the opportunity cost of capital, have been considered. Furthermore, the higher the NPV, the more profitable the project” (Reiter and Song, 2018, p.277). This term is new to me and just by this definition it is hard for me to really get an understanding.

Internal rate of return measures the expected rate (percentage) of return on an investment. (Reiter and Song, 2018, p.269).

Respond: Payback is a term to describe how long it will take for an investment to reach economic breakeven, or how many years it will take to recover the cost of the investment (Reiter & Song, 2018). Although it is a relatively simplistic term and method, it can be an effective way of showing, at least initially, how attractive an investment might be, however it is not infallible. Payback is not used as the only evaluation tool any longer for several reasons. One important way in which payback is not the best method for assessing the attractiveness of an investment is that it only measures up to the recovered cost, and does not measure cash flow after this time (Reiter & Song, 2018). Although a shorter payback period is generally a good thing, it is not a full picture about the quality of an investment. If the amount of cash a potential investment brings in increases after the payback period, this is not taken to account using payback.

Net present value utilizes discounted cash flow (DCF) analysis to determine the return on investment (ROI); it can also be referred to as a DCF profitability measure (Reiter & Song, 2018). It is calculated by finding the current value of each cash flow, both inflows and outflows, after being discounted at the opportunity cost of capital, and then summing the present values (Reiter & Song, 2018). A positive NVP indicates that the project will likely be profitable, while a negative NVP is not expected to be profitable, an NVP of 0 means the project will breakeven (Reiter & Song, 2018).

Internal rate of return is another return on investment measure that utilizes discounted cash flow analysis, and is similar to NVP, but they do differ. While NVP measures a projects dollar profitability, an IRR measures the percent profitability of a project, or its projected rate of return (Reiter & Song, 2018). NVP is somewhat simpler to interpret than IRR, as it is simply if an NVP is positive or negative that indicates the profitability of a project. However, for an IRR to indicate profitability the IRR must exceed the project cost of capital, or the opportunity cost rate (Reiter & Song, 2018). If the IRR is less than the project cost of capital this indicates a potential financial loss for the organization.