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- April 20, 2024 at 1:47 pm #704340
Hi, I wondered whether someone could help me work out why two different methods of calculating the payback period have been used that give 2 different answers.
In the BPP P&R pg36, Q92 is as follows:
NW Co is considering investing $46k in a new delivery lorry that will last 4 years, after which time it will be sold for $7k. Dep’n is SL. Forecasting profits/(losses) to be generated by the machine are below:
Yr1 $16.5k
Yr2 $23.5k
Yr3 $13.5k
Yr4 ($1.5k)
Assuming operational cash flows arise evening over the year, what is the payback period for the investment.
Answer:
Dep’n = ($46,000-$7000)/4 = $9,750Time 0 Investment ($46,000)
Time 1 Cash flow $26,250 (Profit in Yr1 $16.5+Depn $9,750)
Cumulative CF ($19,750)Time 2 Cash flow $33,250
Cumulative CF $13,500Therefore payback period = 1+($19,750/$33,520) = 1.59 * 12 = 19 months, i.e. 1 year 7 months.
When I apply this method to the following question the answer is wrong and the method used to calculate the correct answer is also completely different:
Q98A project has average estimated cash flows of $3k/yr with an initial investment of $9k.
Depn is SL with no residual value and the project has a 5 year life span. The company has a target return on ROCE of 15% and a target payback period of 2.5. ROCE is based on initial investment.
Under which investment appraisal method, using the company’s targets, will the project be accepted?The answer is none.
However when I use the method above to get the answer for payback it differs from BPP:Depn = $9,000 / 5 = $1,800
Time 0 Investment ($9,000)
Time 1 Cash flow $4,800
Cumulative CF ($4,200)Time 2 Cash flow $4,800
Cumulative CF $600Payback period = 1+($4,200/$4,800) = 1.875 * 12 = 22.5 months, therefore 1yr 10.5 months.
BPPs method:
9,000 / 3000 = 3 yearsWhat I am missing in Q98 that suggests I should be doing the simple calc of $9k/$3k?
Thanks
April 21, 2024 at 8:00 am #704364In the first question (BPP P&R pg36, Q92), the payback period is calculated by considering the cash flows generated by the investment. The cash flows are the profits plus the depreciation expense. By adding up the cash flows until they equal or exceed the initial investment, the payback period is determined to be 1 year and 7 months.
In the second question (Q98), the payback period is calculated differently.
Because it is simply the initial investment divided by the average annual cash flows. In this case, the initial investment is $9,000 and the average annual cash flows are $3,000. Therefore, the payback period is 3 years.The reason for the difference in calculation methods is that different scenarios and information are provided in each question. The first question provides specific cash flows and depreciation, while the second question only provides average cash flows.
There are often different ways of doing the same thing…
It is important to use the appropriate method based on the information given in each question. If you’re unsure read the question again. - AuthorPosts
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