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Home > More Subjects > Accounting Principles II > Capital Budgeting Techniques Current Liabilities Long-Term Liabilities Partnerships Corporations Investments Statement of Cash Flows Financial Statement Analysis Managerial and Cost Accounting Concepts Traditional Cost Systems Activity-Based Costing Cost-Volume-Profit Relationships Budgets Flexible Budgets and Standard Costs Incremental Analysis Capital Budgeting
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Payback technique
The payback measures the length of time it takes a company to recover in cash its initial investment. This concept can also be explained as the length of time it takes the project to generate cash equal to the investment and pay the company back. It is calculated by dividing the capital investment by the net annual cash flow. If the net annual cash flow is not expected to be the same, the average of the net annual cash flows may be used.
For the Cottage Gang, the cash payback period is three years. It was calculated by dividing the $150,000 capital investment by the $50,000 net annual cash flow ($250,000 inflows - $200,000 outflows)
The shorter the payback period, the sooner the company recovers its cash investment. Whether a cash payback period is good or poor depends on the company's criteria for evaluating projects. Some companies have specific guidelines for number of years, such as two years, while others simply require the payback period to be less than the asset's useful life. When net annual cash flows are different, the cumulative net annual cash flows are used to determine the payback period. If the Turtles Co. has a project with a cost of $150,000, and net annual cash inflows for the first seven years of the project are: $30,000 in year one, $50,000 in year two, $55,000 in year three, $60,000 in year four, $60,000 in year five, $60,000 in year six, and $40,000 in year seven, then its cash payback period would be 3.25 years. See the example that follows.
The cash payback period is easy to calculate but is actually not the only criteria for choosing capital projects. This method ignores differences in the timing of cash flows during the project and differences in the length of the project. The cash flows of two projects may be the same in total but the timing of the cash flows could be very different. For example, assume project LJM had cash flows of $3,000, $4,000, $7,000, $1,500, and $1,500 and project MEM had cash flows of $6,000, $5,000, $3,000, $2,000, and $1,000. Both projects cost $14,000 and have a payback of 3.0 years, but the cash flows are very different. Similarly, two projects may have the same payback period while one project lasts five years beyond the payback period and the second one lasts only one year.
4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
0.92 38 0.90 57 0.88 80 0.87 06 0.85 35 0.83 68 0.82 03 0.80 43 0.78 85 0.77 30 0.75 79 0.74 30 0.72 84 0.71 42 0.70 02 0.68 64 0.67 30
0.85 48 0.82 19 0.79 03 0.75 99 0.73 07 0.70 26 0.67 56 0.64 96 0.62 46 0.60 06 0.57 75 0.55 53 0.53 39 0.51 34 0.49 36 0.47 46 0.45 64
0.82 27 0.78 35 0.74 62 0.71 07 0.67 68 0.64 46 0.61 39 0.58 47 0.55 68 0.53 03 0.50 51 0.48 10 0.45 81 0.43 63 0.41 55 0.39 57 0.37 69
0.79 0.73 21 50 0.74 0.68 73 06 0.70 0.63 50 02 0.66 0.58 51 35 0.62 0.54 74 03 0.59 0.50 19 02 0.55 0.46 84 32 0.52 0.42 68 89 0.49 0.39 70 71 0.46 0.36 88 77 0.44 0.34 23 05 0.41 0.31 73 52 0.39 0.29 36 19 0.37 0.27 14 03 0.35 0.25 03 02 0.33 0.23 05 17 0.31 0.21 18 45
0.68 30 0.62 09 0.56 45 0.51 32 0.46 65 0.42 41 0.38 55 0.35 05 0.31 86 0.28 97 0.26 33 0.23 94 0.21 76 0.19 78 0.17 99 0.16 35 0.14 86
0.63 55 0.56 74 0.50 66 0.45 23 0.40 39 0.36 06 0.32 20 0.28 75 0.25 67 0.22 92 0.20 46 0.18 27 0.16 31 0.14 56 0.13 00 0.11 61 0.10 37
0.59 21 0.51 94 0.45 56 0.39 96 0.35 06 0.30 75 0.26 97 0.23 66 0.20 76 0.18 21 0.15 97 0.14 01 0.12 29 0.10 78 0.09 46 0.08 29 0.07 28
0.55 0.51 0.48 23 58 23 0.47 0.43 0.40 61 71 19 0.41 0.37 0.33 04 04 49 0.35 0.31 0.27 38 39 91 0.30 0.26 0.23 50 60 26 0.26 0.22 0.19 30 55 38 0.22 0.19 0.16 67 11 15 0.19 0.16 0.13 54 19 46 0.16 0.13 0.11 85 72 22 0.14 0.11 0.09 52 63 35 0.12 0.09 0.07 52 85 79 0.10 0.08 0.06 79 35 49 0.09 0.07 0.05 30 08 41 0.08 0.06 0.04 02 00 51 0.06 0.05 0.03 91 08 76 0.05 0.04 0.03 96 31 13 0.05 0.03 0.02 14 65 61 Cash Inflows
0.45 14 0.37 00 0.30 33 0.24 86 0.20 38 0.16 70 0.13 69 0.11 22 0.09 20 0.07 54 0.06 18 0.05 07 0.04 15 0.03 40 0.02 79 0.02 29 0.01 87
Cash from
$250,000
Customers (1) Operating Costs (2) Estimated Useful Life Minimum Required Rate of Return Annual Net Cash Flows ($250,000 $200,000) (1) - (2) 200,000 7 years 12% $50,000 Salvage Value 5,000
Present Value of Cash Flows Annual Net Cash Flows ($50,000 4.5638) $228,190 Salvage Value ($5,000 .4523) Total Present Value of Net Cash Inflows Less: Investment Cost Net Present Value 2,262 230,452 (150,000) $ 80,452
When net cash flows are not all the same, a separate present value calculation must be made for each period's cash flow. A financial calculator or a spreadsheet can be used to calculate the present value. Assume the same project information for the Cottage Gang's investment except for net cash flows, which are summarized with their present value calculations below. Estimated Annual Net Cash Period Flow (1) 1 2 3 4 5 6 7 $ 44,000 55,000 60,000 57,000 51,000 44,000 39,000 12% Discount Factor Present Value (1) (2) (2) .8929 .7972 .7118 .6355 .5674 .5066 .4523 $ 39,288 43,846 42,708 36,224 28,937 22,290 17,640 $230,933
Totals $350,000 The NPV of the project is $83,195, calculated as follows: Present Value of Cash Flows Annual Net Cash Flows $230,933
2,26
Total Present Value of Net Cash Inflows 233,195 Less: Investment Cost Net Present Value (150,000) $ 83,195
The difference between the NPV under the equal cash flows example ($50,000 per year for seven years or $350,000) and the unequal cash flows ($350,000 spread unevenly over seven years) is the timing of the cash flows. Most companies' required rate of return is their cost of capital. Cost of capital is the rate at which the company could obtain capital (funds) from its creditors and investors. If there is risk involved when cash flows are estimated into the future, some companies add a risk factor to their cost of capital to compensate for uncertainty in the project and, therefore, in the cash flows. Most companies have more project proposals than they do funds available for projects. They also have projects requiring different amounts of capital and with different NPVs. In comparing projects for possible authorization, companies use a profitability index. The index divides the present value of the cash flows by the required investment. For the Cottage Gang, the profitability index of the project with equal cash flows is 1.54, and the profitability index for the project with unequal cash flows is 1.56.
0.980 0.961 0.952 0.943 0.92 0.90 0.89 0.87 0.86 0.84 0.83 0.81 4 5 4 4 59 91 29 72 21 75 33 97 1.941 1.886 1.859 1.833 1.78 1.73 1.69 1.64 1.60 1.56 1.52 1.49 6 1 4 4 33 55 01 67 52 56 78 15 2.883 2.775 2.723 2.673 2.57 2.48 2.40 2.32 2.24 2.17 2.10 2.04 9 1 2 0 71 69 18 16 59 43 65 22 3.807 3.629 3.546 3.465 3.31 3.16 3.03 2.91 2.79 2.69 2.58 2.49 7 9 0 1 21 99 73 37 82 01 87 36 4.713 4.451 4.329 4.212 3.99 3.79 3.60 3.43 3.27 3.12 2.99 2.86 5 8 5 4 27 08 48 31 43 72 06 36 5.601 5.242 5.075 4.917 4.62 4.35 4.11 3.88 3.68 3.49 3.32 3.16 4 1 7 3 29 53 14 87 47 76 55 69 6.472 6.002 5.786 5.582 5.20 4.86 4.56 4.28 4.03 3.81 3.60 3.41 0 1 4 4 64 84 38 83 86 15 46 55 7.325 6.732 6.463 6.209 5.74 5.33 4.96 4.63 4.34 4.07 3.83 3.61 5 7 2 8 66 49 76 89 36 76 72 93 8.162 7.435 7.107 6.801 6.24 5.75 5.32 4.94 4.60 4.30 4.03 3.78 2 3 8 7 69 90 82 64 65 30 10 63 8.982 8.110 7.721 7.360 6.71 6.14 5.65 5.21 4.83 4.49 4.19 3.92 6 9 7 1 01 46 02 61 32 41 25 32
11 12 13 14 15 16 17 18 19 20
9.786 8.760 8.306 7.886 7.13 6.49 5.93 5.45 5.02 4.65 4.32 4.03 8 5 4 9 90 51 77 27 86 60 71 54 10.57 9.385 8.863 8.383 7.53 6.81 6.19 5.66 5.19 4.79 4.43 4.12 53 1 3 8 61 37 44 03 71 32 92 74 11.34 9.985 9.393 8.852 7.90 7.10 6.42 5.84 5.34 4.90 4.53 4.20 84 6 6 7 38 34 35 24 23 95 27 28 12.10 10.56 9.898 9.295 8.24 7.36 6.62 6.00 5.46 5.00 4.61 4.26 62 31 6 0 42 67 82 21 75 81 06 46 12.84 11.11 10.37 9.712 8.55 7.60 6.81 6.14 5.57 5.09 4.67 4.31 93 84 97 2 95 61 09 22 55 16 55 52 13.57 11.65 10.83 10.10 8.85 7.82 6.97 6.26 5.66 5.16 4.72 4.35 77 23 78 59 14 37 40 51 85 24 96 67 14.29 12.16 11.27 10.47 9.12 8.02 7.11 6.37 5.74 5.22 4.77 4.39 19 57 41 73 16 16 96 29 87 23 46 08 14.99 12.65 11.68 10.82 9.37 8.20 7.24 6.46 5.81 5.27 4.81 4.41 20 93 96 76 19 14 97 74 78 32 22 87 15.67 13.13 12.08 11.15 9.60 8.36 7.36 6.55 5.87 5.31 4.84 4.44 85 39 53 81 36 49 58 04 75 62 35 15 16.35 13.59 12.46 11.46 9.81 8.51 7.46 6.62 5.92 5.35 4.86 4.46 14 03 22 99 81 36 94 31 88 27 96 03
Assume the Cottage Gang has expected annual net income of $5,572 with an investment of $150,000 and a salvage value of $5,000. This proposed project has a 7.2% annual rate of return ($5,572 net income $77,500 average investment).
The annual rate of return should not be used alone in making capital budgeting decisions, as its results may be misleading. It uses accrual basis of accounting and not actual cash flows or time value of money.
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