Compute the payback period - example, Finance Basics

Compute the Payback Period - Example

Cedes restriction has the following details of two (2) of the future production plans. Just one of these machines will be purchased and such venture would be use to be virtually exclusive. The Standard model costs of £50,000 and the deluxe cost of £88,000 payable instantly.  The input of the givens is required for both machines as:

i) Installation costs of £20,000 for Standard and £40,000 for the Deluxe

ii)  A £10,000 working capital during their working lives.

Both of machines have no supposed scrap value at finish of their expected working lives of 4 years for the Standard machine and six years for the Deluxe. The operating pre-tax net cash flows related with the two machines are as follows:

Year

1

2

3

4

5

6

Standard

Deluxe

28,500

36,030

25,860

30,110

24,210

28,380

23,410

25,940

-

38,500

-

35,100

The deluxe machine has simply been introduced in the market and has not been fully tested in the operating situation, since of the high risk included the appropriate discount rate for the deluxe machine is supposed to be 14 percent per annum, 2 percent higher rather than the rate of the standard machine. Such company is proposing the purchase of either machine along with a term loan at a fixed rate of interest of 11 percent per annum, taxation at 30 percent is payable on operating cash-flows one year in arrears and capital allowance are obtainable at 25 percent per annum on a decreasing balance basis.

Required

Used for both the deluxe and the Standard machines, compute the payback period.

Solution

Establish the cash flows as given:

Pre-tax inflows (EBDT)                                    XX

Less depreciation = capital allowance               (XX)

Earnings before tax                                        XX

Less tax                                                        (XX)

Earnings after tax                                          XX

Add back capital allowance/depreciation          XX

Operating cash flows                                     XX

Note   

Capital allowance/depreciation is a non-cash item therefore whenever deducted for tax reason, it must be added back to eliminate the non-cash flow effects.

Cash flows for standard machine:

Year

1

2

3

4

5

Pretax inflow

Less allowance (depreciation)

Taxable cash inflows

Tax @ 30% 1 yr in arrears

 

Add back capital allowance

Operating cash flows

Add working capital realised

Total cash flows

28,500

17,500

11,000

   -___

11,000

17,500

28,500

         -

28,500

25,850

13,125

12,735

3.300

9,435

13,125

22,560

         -

22,560

24,210

  9,844

14,366

(3,831)

10,545

9,844

20,389

         -

20,389

23,410

  7,383

16,027

(4,310)

11,717

7,383

19,100

10,000

29,100

-

-

 

(4,808)

(4,808)

-

(4,808)

         -

(4,808)

Cash flows for Deluxe machine:

Year

1

2

3

4

5

6

7

Pretax inflows

Less (depreciation)

 

Tax @ 30% in arrears

 

Inflows after tax

Add back capital

Allowance

 

Add back w/capital

Total cash flows

36,030

32,000

4,030

        -

 

4,030

 

32,000

 

         -

36,030

30,110

24,000

6,110

(1,209)

 

4,901

 

24,000

28,901

         -

28,599

28,380

18,000

10,380

(1,833)

 

8,547

 

18,000

26,547

         -

26,547

25,940

13,500

12,440

(3,114)

 

9,326

 

13,500

22,826

          -

22,826

38,560

10,125

28,435

(3,732)

 

24,703

 

10,125

34,828

         -

34,828

35,100

  7,594

27,506

(8,531)

 

18,975

 

7,594

26,569

10,000

36,569

-

-

-

(8,252)

 

(8,252)

 

        -

(8,252)

        -

(8,252)

                                                            Standard                                                         Deluxe

Cost     50,000 + 20,000                      70,000             88,000 + 40,000                      128,000

Year

Cash flows

Accumulated

Cash flows

Accumulated

1

2

3

4

5

6

7

28,500

22,560

20,389

29,100

 (4,808)

   -

   -

  28,500

  51,060

  71,449

100,549

  95,741

     -

     -

36,030

28,901

26,547

22,826

34,828

36,569

( 8,252)

  36,030

  64,931

  91,478

114,304

149,132

185,701

179,449

  • Pay back duration for standard: Initial capital of Sh.7,000 is recovered throughout year 3. After year 2, we require 70,000 - 9,060 = 18,940 to recover initial capital out of year 3 cash flows of Sh.20,389.
  • Applying the similar concept for Deluxe, payback period would be as follows:

4 + (128,000 - 114,304) / 34,828 = 4.39 years

Posted Date: 1/30/2013 5:05:01 AM | Location : United States







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