What does this mean?

Opportunity cost, you'll remember, has to do with the next best alternative forgone.

It has to do with the kind of side effects that

come from doing the project versus not doing the project.

So what we're doing with this new bidded project is that we're assuming

that the profits of another similar product line are going to reduce,

because there will be substitution or erosion, okay?

We'll assume that effect is going to be $1,000 annually.

So because it's attributable to our project,

we must pay for it, and that's why we have this line for opportunity cost.

So let's see the overall impact.

If this project is causing us to reduce profit of

another product that we sell, we must pay for it and account for it here.

So I'm going to assume that number is 1,000 and

make sure that this impact is reflected in my cash flow.

I'm now ready to calculate my cash flows.

Let's use another pen to highlight the numbers.

What do we have?

We have -23,000 in time 0.

That's what we need to spend today.

This is real cash.

What are we getting in a year?

We're going to take the sum of these numbers here, which works out to 10,800.

Of course this is a plus.

Let's do it again.

It's the same number, so the amount is going to be 10,800 once again.

And then, because we have a recovery of working capital,

the amount Is actually $2,000 more, or 12,800 for the last year.

So folks, this is what we were after.

This is exactly what we assumed in our previous video when we

started applying techniques.

These are the inputs that go into our techniques.

And now, while we have this fresh in our minds,

let's just apply the three techniques that we learned.

The first technique, you'll recall, was the payback period model.

The payback period said, how long will it take to recover this initial investment?

How much time will it take?

And it's not that difficult to calculate at all,

because what I'm doing with the payback is I'm just accumulating

the cash flows to see when I get this money back.

I need $23,000.

I'm getting $10,800 in a year.

That means I still need $12,200.

Now, you can see I'm getting another $10,800 in the second year.

But if I do the math here, of course, I still need -1,400.

You can see that I get that in the third year.

To get the proportion, I simply divide the amount I need with the amount I'm getting.

That's 1,400 divided by 12,800, and

that gives me a ratio of 0.11, and so

my payback is going to be 2 years 0.11, just over two years.

That's the precise calculation, okay?