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Return on Investment – Payback Method

Return on Investment – Payback Method. By R. S. Miolla. Agenda. 1) What is return on investment (ROI)? 2)One method of ROI, the Payback Method. 1) What is ROI?. Also called a capital budgeting decision. Invest now, get return later. Return is cash inflow.

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Return on Investment – Payback Method

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  1. Return on Investment – Payback Method By R. S. Miolla

  2. Agenda • 1) What is return on investment (ROI)? • 2)One method of ROI, the Payback Method.

  3. 1) What is ROI? • Also called a capital budgeting decision. • Invest now, get return later. • Return is cash inflow. • Simple case: Invest $3 million, cash inflows of $4 million => (inflow-investment)/investment => 1M/3M = .33 or 33% ROI.

  4. 1) ROI or Capital Budgeting • A long-term investment • Example: buying equipment, opening a plant • Based on cash flows, not earnings • Statement of cash flows not the income statement

  5. 2) Payback Method • Computes how long until paid back. • Does not use the time value of money. • Ignores cash flows after payback. • Easy to compute and understand.

  6. Investment Defined • $10,000 cash outflow (investment) • Cash inflows: • Investment A Investment B • Year 1 6000 2000 • 2 4000 2000 • 3 2000 2000 • 4 0 5000 • 5 0 10,000

  7. Payback Method • Investment A: • 10,000 – 6000 = 4000 1 year • 4000 – 4000 = 0 2 years to payback • Investment B: • 10000 – 2000 =8000 1 year • 8000 – 2000 = 6000 2 years • 6000 – 2000 = 4000 3 years • 4000 – 5000 = -1000 so 4000/5000 = .8 years, 3.8 years to payback

  8. Summary • Payback is one method for computing ROI. • It computes time to payback. • Easy to compute and understand. • It does not use time value. • It ignores flows after payback.

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