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:

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:

Cash flows for Deluxe machine:

                                                            Standard                                                         Deluxe

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

• 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