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PAY BACK METHOD

Delta Company is planning to purchase a machine known as machine X.


Machine X would cost $25,000 and would have a useful life of 10 years with zero
salvage value. The expected annual cash inflow of the machine is $10,000.

Required: Compute payback period of machine X and conclude whether or not


the machine would be purchased if the maximum desired payback period of Delta
company is 3 years.

Solution:

Since the annual cash inflow is even in this project, we can simply divide the
initial investment by the annual cash inflow to compute the payback period. It is
shown below:

Payback period = $25,000/$10,000


= 2.5 years

According to payback period analysis, the purchase of machine X is desirable


because its payback period is 2.5 years which is shorter than the maximum
payback period of the company.

Example 2:

Due to increased demand, the management of Rani Beverage Company is


considering to purchase a new equipment to increase the production and
revenues. The useful life of the equipment is 10 years and the company’s
maximum desired payback period is 4 years. The inflow and outflow of cash
associated with the new equipment is given below:

Initial cost of equipment: $37,500

Annual cash inflows:

Sales: $75,000

Annual cash Outflows:

Cost of ingredients: $45,000


Salaries expenses: $13,500
Maintenance expenses: $1,500

Non cash expenses:

Depreciation expense: $5,000


Required: Should Rani Beverage Company purchase the new equipment? Use
payback method for your answer.

Solution:

Step 1: In order to compute the payback period of the equipment, we need to


work out the net annual cash inflow by deducting the total of cash outflow from
the total of cash inflow associated with the equipment.

Computation of net annual cash inflow:

$75,000 – ($45,000 + $13,500 + $1,500)


= $15,000

Step 2: Now, the amount of investment required to purchase the equipment


would be divided by the amount of net annual cash inflow (computed in step 1) to
find the payback period of the equipment.

= $37,500/$15,000
=2.5 years

Depreciation is a non-cash expense and therefore has been ignored while


calculating the payback period of the project.

According to payback method, the equipment should be purchased because the


payback period of the equipment is 2.5 years which is shorter than the maximum
desired payback period of 4 years.

ARR – Example 1

XYZ Company is looking to invest in some new machinery to replace its current
malfunctioning one. The new machine, which costs $420,000, would increase
annual revenue by $200,000 and annual expenses by $50,000. The machine is estimated to
have a useful life of 12 years and zero salvage value.

Step 1: Calculate Average Annual Profit


Inflows, Years 1-12
(200,000*12) $2,400,000
Less: Annual Expenses
(50,000*12) -$600,000
Less: Depreciation -$420,000
Total Profit $1,380,000
Average Annual Profit
(1,380,000/12) $115,000
Step 2: Calculate Average Investment
Average Investment
($420,000 + $0)/2 = $210,000
Step 3: Use ARR Formula
ARR = $115,000/$210,000 = 54.76%

Therefore, this means that for every dollar invested, the investment will return a profit of
about 54.76 cents.

ARR – Example 2

XYZ Company is considering investing in a project that requires an initial investment of


$100,000 for some machinery. There will be net inflows of $20,000 for the first two years,
$10,000 in years three and four, and $30,000 in year five. Finally, the machine has a salvage
value of $25,000.

Step 1: Calculate Average Annual Profit


Inflows, Years 1 & 2
(20,000*2) $40,000
Inflows, Years 3 & 4
(10,000*2) $20,000
Inflow, Year 5 $30,000
Less: Depreciation
(100,000-25,000) -$75,000
Total Profit $15,000
Average Annual Profit
(15,000/5) $3,000
Step 2: Calculate Average Investment
Average Investment
($100,000 + $25,000) / 2 = $62,500
Step 3: Use ARR Formula
ARR = $3,000/$62,500 = 4.8%

Examples of Net Present Value

NPV = Initial Investment + (Annual Cash Flow / Discount Rate) * (1+Inflation


Rate)^Years
To illustrate the concept of NPV, consider the following examples.
Example 1: You invest $2,000 in a project and expect to receive $3,000 in cash flows
over the next five years.
Using the formula above, you would calculate the NPV as follows:
NPV = $2,000 + ($3,000 / 0.04) = $8,250

In this example, the NPV is $8,250, meaning the project is expected to generate a
positive return of $6,250.
Example 2: You invest $2,000 in a project and expect to receive $3,000 in cash flows
over the next five years with an inflation rate of 2%.
Using the formula above, you would calculate the NPV as follows:
NPV = $2,000 + ($3,000 0.04) * (1+0.02)^5 = $8,805
In this example, the NPV is $8,805, which means the project is expected to generate a
positive return of $6,805.
If the expected cash flows in either example had been negative, the NPV would have
been negative, indicating that the project would likely yield a negative return investment.
You can also use NPV to compare two different investments. For example, if you had
two projects with the same expected cash flows but various initial investments and
discount rates, the higher NPV would be the more profitable option.

Internal Rate of Return (IRR): Formula and Examples

The Formula for IRR


The formula used to determine IRR is as follows:

0=NPV=t=1∑T(1+IRR)tCt−C0where:Ct
=Net cash inflow during the period tC0
=Total initial investment costsIRR=The internal rate of returnt=The
number of time periods
IRR Example
Assume a company is reviewing two projects. Management must decide
whether to move forward with one, both, or neither. Its cost of capital is
10%. The cash flow patterns for each are as follows:

Project A

• Initial Outlay = $5,000


• Year one = $1,700
• Year two = $1,900
• Year three = $1,600
• Year four = $1,500
• Year five = $700

Project B

• Initial Outlay = $2,000


• Year one = $400
• Year two = $700
• Year three = $500
• Year four = $400
• Year five = $300

The company must calculate the IRR for each project. The initial outlay
(period = 0) will be negative. Solving for IRR is an iterative process using
the following equation:

$0 = Σ CFt ÷ (1 + IRR)t

where:

• CF = net cash flow


• IRR = internal rate of return
• t = period (from 0 to last period)

-or-

$0 = (initial outlay * −1) + CF1 ÷ (1 + IRR)1 + CF2 ÷ (1 + IRR)2 + ... + CFX


÷ (1 + IRR)X

Using the above examples, the company can calculate IRR for each
project as:

IRR Project A

$0 = (−$5,000) + $1,700 ÷ (1 + IRR)1 + $1,900 ÷ (1 + IRR)2 + $1,600 ÷ (1


+ IRR)3 + $1,500 ÷ (1 + IRR)4 + $700 ÷ (1 + IRR)5

IRR Project A = 16.61 %

IRR Project B

$0 = (−$2,000) + $400 ÷ (1 + IRR)1 + $700 ÷ (1 + IRR)2 + $500 ÷ (1 +


IRR)3 + $400 ÷ (1 + IRR)4 + $300 ÷ (1 + IRR)5

IRR Project B = 5.23 %

Given that the company’s cost of capital is 10%, management should


proceed with Project A and reject Project B.

Case study in final accounts


Case Study: Final Accounts Preparation for XYZ Ltd
Background: XYZ Ltd is a small retail business selling sports equipment. The financial year
ended on December 31, 2023. Prepare the final accounts for the year ended December 31,
2023.

Trial Balance as at December 31, 2023:

Particulars Debit ($) Credit ($)


Sales 200,000
Sales Returns 5,000
Purchases 120,000
Carriage Inwards 3,000
Wages 30,000
Rent Expense 15,000
Rates and Taxes 5,000
Insurance 2,000
Electricity 3,500
Advertising 8,000
Discount Allowed 2,500
Discount Received 1,500
Bad Debts 1,200
Debtors 40,000
Creditors 28,000
Bank Overdraft 7,000
Cash in Hand 1,500
Cash at Bank 10,000
Fixtures and Fittings 25,000
Motor Vehicles 15,000
Loan 20,000
Capital 90,000

Adjustments:

1. Depreciation on Fixtures and Fittings at 10% p.a.


2. Depreciation on Motor Vehicles at 20% p.a.
3. Provide for Bad Debts at 5% of Debtors.
4. Accrued Wages $2,000.
5. Prepaid Insurance $500.
6. Outstanding Rates and Taxes $1,000.
7. Stock on December 31, 2023, $30,000.

Solution:

Trading Account for the Year Ended December 31, 2023


Particulars Amount ($)
Sales 200,000
Less: Sales Returns (5,000)
--------------
Net Sales 195,000
Cost of Goods Sold:
Opening Stock 0
Add: Purchases 120,000
Add: Carriage Inwards 3,000
Less: Closing Stock (30,000)
--------------
Cost of Goods Sold 93,000
Gross Profit 102,000

Profit and Loss Account for the Year Ended December 31, 2023

Particulars Amount ($)


Gross Profit 102,000
Operating Expenses:
Wages 32,000
Rent Expense 15,000
Rates and Taxes 4,000
Insurance 1,500
Electricity 3,500
Advertising 8,000
Discount Allowed 2,500
Depreciation - Fixtures 2,500
Depreciation - Vehicles 3,000
Bad Debts Provision 2,000
--------------
Total Operating Expenses 74,000
Net Profit 28,000

Balance Sheet as at December 31, 2023

Particulars Amount ($)


Assets:
Cash in Hand 1,500
Cash at Bank 10,000
Debtors 40,000
Less: Provision for Bad Debts (2,000)
Stock 30,000
Fixtures and Fittings 22,500
Particulars Amount ($)
Less: Depreciation (2,500)
Motor Vehicles 12,000
Less: Depreciation (3,000)
Prepaid Insurance 500
--------------
Total Assets 111,500
Liabilities:
Creditors 28,000
Accrued Wages 2,000
Bank Overdraft 7,000
Outstanding Rates and Taxes 1,000
Loan 20,000
Capital 90,000
--------------
Total Liabilities and Capital 148,000

This case study demonstrates how to prepare final accounts including the Trading Account,
Profit and Loss Account, and Balance Sheet for a small business like XYZ Ltd.

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