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# Payback:

The payback method focuses on the payback period. The payback period is the length of
time that it takes for a project to recover its initial cost from the net cash inflows that it
generates. This period is sometimes referred to as the time that it takes for an investment
to pay for itself.

The basic principle is that the more quickly the cost of an investment can be recovered,
the more desirable is the investment.

When the annual net cash inflow is the same every year

Investment required
Payback period = Annual net cash inflow

Example:
York Company needs a new milling machine. The company is considering two machines:
machine A and machine B. Machine A costs \$15,000, has a useful life of ten years, and
will reduce operating costs by \$5,000 per year. Machine B costs only \$12,000, will also
reduce operating costs by \$5,000 per year, but has a useful life of only five years. Which
machine should be purchased according to the payback method?
Solutions:

## Machine A payback period \$15,000 / \$5,000= 3.0 years

Machine B payback period \$12,000 / \$5,000= 2.4 years

## According to the payback calculations, York Company should purchase machine B

because it has a shorter payback period than machine A.

## Not a true measure of profitability of an investment.

It simply tells a manager how many years are required to recover the original investment
A shorter payback period does not always mean that one investment is more desirable
than another
To illustrate, refer back to Example above. Machine B has a shorter payback period
than machine A, but it has a useful life of only 5 years rather than 10 years for machine
A. Machine B would have to be purchased twiceonce immediately and then again
after the fifth yearto provide the same service as just one machine A. Under these
circumstances, machine A would probably be a better investment than machine B,
even though machine B has a shorter payback period. Unfortunately, the payback
method ignores all cash flows that occur after the payback period.
Payback method does not consider the time value of money

To illustrate, assume that for an investment of \$8,000 you can purchase either of
the two following streams of cash inflows:

Each stream has a payback period of 4.0 years. Therefore, if payback alone is
used to make the decision, the streams would be considered equally desirable.
However, from a time value of money perspective, stream 2 is much more
desirable than stream 1.
Payback and Uneven Cash Flows

Example:

Canton Brothers wants to enter in the sweater industry in 2017 with an initial
investment of USD 4000. The company expects to earn positive cash flows from 2017
which would be USD 1000. In 2018, there would not be much cash flow in hand
however, in 2019 it expects USD 2000 in their pocket. However in the forth year the
company foresees further investment of USD 2000 and in that year the cash inflow
would be USD 1000. For 5th, 6th and 7th year the company forecasts to earn USD 500,
USD 3000 and USD 2000 as positive cash flows.

Solutions:

## Payback = 5+ (1500/3000) = 5.5 Years

Accounting Rate of Return

ARR calculates the return, generated from net income of the proposed capital
investment. The ARR is a percentage return.
Example:
A Rahman hires people on a part-time basis to sort eggs. The cost of this hand-
sorting process is \$30,000 per year. The company is investigating an egg-sorting
machine that would cost \$90,000 and have a 15-year useful life. The machine
would have negligible salvage value, and it would cost \$10,000 per year to operate
and maintain. The egg sorting equipment currently being used could be sold now
for a scrap value of \$2,500.

## Find out ARR

Internal rate of return
A cost of capital at which the NPV of a project would be 0 (zero).
IRR is usually found via interpolation using two discount rates.
Figure 1:
A company is considering expanding its business. The expansion will cost CU 350,000
initially for the premises and a further CU 150,000 to refurbish the premises with
new equipment. Cash flow projections from the project show the following
cash flows over the next six years.

## Year Net cash flows

Year CU
1 70,000
2 70,000
3 80,000
4 100,000
5 100,000
6 120,000
The equipment will be depreciated to a zero resale value over the same period and,
after the sixth year, it is expected that the new business could be sold for CU350,000.
Requirements
Calculate
(a) The payback period for the project
(b) The ARR (using the average investment method)
(c) The NPV of the project. Assume the relevant cost of capital is 12%
(d) The IRR of the project