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