I really enjoyed the lectures apart from the IRR. The internal Rate of Return was not cleared to me i must confess honestly. Not at present. Most students are already used to spreadsheets if you are not then download one — there are many free ones available on the internet and have a play.

Why no need to add in the scrap value in year 4? If you are, then the scrap value is in both answers. The answer to Q 1 shows the two flows at time 4 separately 50, and 20, the answer to Q2 should the two together 70, My questions is about the high low method. Your quickest way to use whether use for the questions when asked step up costs only and needs to add back that set up costs in the fixed costs? In case the initial cash outflow is not recovered over the life of the project which has some scrap value, then should we consider the cash inflow from scrap in our calculation for payback period.

If the rate given gives a positive NPV then your guess should be a higher rate. If it gives a negative NPV then your guess should be a lower rate. We calculate the present value of each year so that we can calculate how many years it takes to get backfor the discounted payback period.

I cant get the question 2 in test for this chapter, please help. You can use any percentage as the second guess. The answer to question 4 is D.

By the end of three years, the total cash received isThe payback period is the time to get back the initial investment ofand so this is going to be less that or within 3 years. From the discount tables. Have you watched the previous lecture on investment appraisal — part A? You must be logged in to post a comment. Comments Thanku so much sir… your lectures really helped….

Log in to Reply. Thank you Open Tuitionthis lecturer is a great one and has helped me a lot in the F2 Paper. Any questions in the exam are only very simple use of spreadsheets with no advanced features.

I assume you are asking about the test questions at the end of the chapter. It makes no difference at all! I see. This is my mistake. Now I got it. Tq john. Now i get the clear pic about this topic! Your lecture notes is very useful! Q:what is the total cost at an activity level of 20, units? You calculation of the fixed cost is wrong. So the total cost will be — x 5.

PS this page is for comments on the lecture on payback period.The payback period refers to the amount of time it takes to recover the cost of an investment. Moreover, it's how long it takes for the cash flow of income from the investment to equal its initial cost. This is usually expressed in years.

Most of what happens in corporate finance involves capital budgeting — especially when it comes to the values of investments. Most corporations will use payback period analysis in order to determine whether they should undertake a particular investment. But there are drawbacks to using the payback period in capital budgeting. Payback period analysis is favored for its simplicity, and can be calculated using this easy formula:.

This analysis method is particularly helpful for smaller firms that need the liquidity provided by a capital investment with a short payback period.

The sooner money used for capital investments is replaced, the sooner it can be applied to other capital investments. A quicker payback period also reduces the risk of loss occurring from possible changes in economic or market conditions over a longer period of time.

When considering two similar capital investments, a company will be inclined to choose the one with the shortest payback period. The payback period is determined by dividing the cost of the capital investment by the projected annual cash inflows resulting from the investment. Some companies rely heavily on payback period analysis and only consider investments for which the payback period does not exceed a specified number of years.

So, longer investment periods are typically not desired. Despite its appeal, the payback period analysis method has some significant drawbacks. The first is that it fails to take into account the time value of money TVM and adjust the cash inflows accordingly. The TVM is the idea that the value of cash today will be worth more than in the future because of the present day's earning potential.

Furthermore, the payback analysis fails to consider inflows of cash that occur beyond the payback period, thus failing to compare the overall profitability of one project as compared to another. For example, two proposed investments may have similar payback periods. But cash inflows from one project might steadily decline following the end of the payback period, while cash inflows from the other project might steadily increase for several years after the end of the payback period.

Since many capital investments provide investment returns over a period of many years, this can be an important consideration. The simplicity of the payback period analysis falls short in not taking into account the complexity of cash flows that can occur with capital investments. In reality, capital investments are not merely a matter of one large cash outflow followed by steady cash inflows. Additional cash outflows may be required over time, and inflows may fluctuate in accordance with sales and revenues.

This method also does not take into account other factors such as risk, financing or any other considerations that come into play with certain investments. Due to its limitations, payback period analysis is sometimes used as a preliminary evaluation, and then supplemented with other evaluations, such as net present value NPV analysis or the internal rate of return IRR. The payback period can be a valuable tool for analysis when used properly to determine whether a business should undertake a particular investment.

However, this method does not take into account several key factors including the time value of money, any risk involved with the investment or financing.The term mutually exclusive investments mean: a. Choose only the best investments. Selection of one investment precludes the selection of an alternative. The elite investment opportunities will get chosen. There are no investment options available. The cash flows are as follows:.

Based on the payback method, which of the two projects should be chosen? Project A which has a payback period of 2. Project B which has a payback period of 2. Which method provides more confidence, the payback method or the net present value method? Payback because it provides a good timetable. Payback because it tells you when you break even.

### ACCA F2 Investment appraisal – Payback period

Net present value because it considers all inflows and outflows and the time value of money. Net present value because it does not need to use cost of capital. The Pan American Bottling Co. The annual cash flows have the following projections. What is the internal rate of return? Should Pan American buy the machine?

NPV does not provide enough information. IRR is higher than the cost of capital. Big Sky Construction Company is considering two new investments. Project E calls for the purchase of earth-moving equipment.We appreciate your knowledge sharing approach. It is helping a lot. Please visit the page PMP Tips. You may get some useful tips there. Hello Manick Need help with this questions The following should be used for questions 15 through A project manager is assigned to a project early in the project lifecycle.

One of the things that must be done is to do a justification for the project. Since very little information is known about the project, the estimates are considered to be rough estimates.

What is the payback period for this project? One year b. Two years c. Three years d. Four years What is the net cash flow at the end of five years? Greater than the total cash flow without the net present value applied b. Less than the total cash flow without the net present value applied c. The same as the total cash flow without the net present value applied d.

Unable to be calculated with the information supplied. Hi, here are my answers to your questions: Qn. ICalculate the net cash flow at the end of each year. At the end of year 1, you have k. At the end of year 2, you have k. So, three years is the payback period. NPV is always lesser than the future value.

Thanks Harwinder for your comment.

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Could you please provide a direct link to the free questions?. It would be useful if you could update the info on your page. Thanks a lot for the information and details provided on your page Great news Sonali Bose. Congrats and welcome to the club!Under payback methodan investment project is accepted or rejected on the basis of payback period. Payback period means the period of time that a project requires to recover the money invested in it.

Unlike net present value and internal rate of return methodpayback method does not take into account the time value of money. According to payback method, the project that promises a quick recovery of initial investment is considered desirable. For example, if a company wants to recoup the cost of a machine within 5 years of purchase, the maximum desired payback period of the company would be 5 years. The purchase of machine would be desirable if it promises a payback period of 5 years or less.

The Delta company is planning to purchase a machine known as machine X. 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. 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:. According to payback period analysis, the purchase of machine X is desirable because its payback period is 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 inflow and outflow of cash associated with the new equipment is given below:. Required: Should Rani Beverage Company purchase the new equipment? Use payback method for your answer. Step 1: In order to compute the payback period of the equipment, we need to workout the net annual cash inflow by deducting the total of cash outflow from the total of cash inflow associated with the equipment.

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. Depreciation is a non-cash expense and has therefore 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. Where funds are limited and several alternative projects are being considered, the project with the shortest payback period is preferred. It is explained with the help of the following example:. The management of Health Supplement Inc. Two types of machines are available in the market — machine X and machine Y.

According to payback method, machine Y is more desirable than machine X because it has a shorter payback period than machine X. In the above examples we have assumed that the projects generate even cash inflow but many projects usually generate uneven cash flow. In such situations, we need to compute the cumulative cash inflow and then apply the following formula:. Required: Compute payback period of the investment.

Should the investment be made if management wants to recover the initial investment in 3 years or less? Because the cash inflow is uneven, the payback period formula cannot be used to compute the payback period. We can compute the payback period by computing the cumulative net cash flow as follows:. The payback period for this project is 3. Please I need help in solving this question.

Below at the data of 2 machines being proposed for acquisition by a university as well as the annual net cash benefit generated by each of them. Machine a. Machine b Initial cost. Pls help me in solving this problem. Umar PLC. The firm uses straight line method of depreciation. The annual profit charging depreciation is Answer is machine A because it will take 3.Payback period is the time in which the initial outlay of an investment is expected to be recovered through the cash inflows generated by the investment.

It is one of the simplest investment appraisal techniques. Since cash flow estimates are quite accurate for periods in the near future and relatively inaccurate for periods in distant future due to economic and operational uncertainties, payback period is an indicator of risk inherent in a project because it takes initial inflows into account and ignores the cash flows after the point at which the initial investment is recovered.

Projects having larger cash inflows in the earlier periods are generally ranked higher when appraised with payback period, compared to similar projects having larger cash inflows in the later periods. The formula to calculate the payback period of an investment depends on whether the periodic cash inflows from the project are even or uneven.

If the cash inflows are even such as for investments in annuitiesthe formula to calculate payback period is:. When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period and then use the following formula:.

Where, A is the last period number with a negative cumulative cash flow; B is the absolute value i. Calculate the payback period of the project. Calculate the payback value of the project.

The longer the payback period of a project, the higher the risk. Between mutually exclusive projects having similar return, the decision should be to invest in the project having the shortest payback period. When deciding whether to invest in a project or when comparing projects having different returns, a decision based on payback period is relatively complex.

## Chapter 15: Multiple choice questions

The decision whether to accept or reject a project based on its payback period depends upon the risk appetite of the management. Management will set an acceptable payback period for individual investments based on whether the management is risk averse or risk taking. This target may be different for different projects because higher risk corresponds with higher return thus longer payback period being acceptable for profitable projects.

For lower return projects, management will only accept the project if the risk is low which means payback period must be short. You are welcome to learn a range of topics from accounting, economics, finance and more.

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**Payback period - Example 3 - Project comparison**

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Question 1. Answer : The payback period is calculated by counting the number of years it will take to recover the cash invested in a project. The payback period is 3. Note that the payback calculation uses cash flows, not net income. Also, the payback calculation does not address a project's total profitability. Rather, the payback period simply computes how fast a company will recover its cash investment. Question 2. Answer : Gross margin or gross profit is defined as sales minus cost of goods sold.

The gross profit ratio or the gross margin ratio expresses the gross profit or gross margin amount as a percentage of sales. Markup is used several ways. Some retailers use markup to mean the difference between a product's cost and its selling price. However, the markup percentage is often expressed as a percentage of cost. Some retailers may use the term markup to mean the increase in the original selling.

Question 3. Answer : The gross margin ratio is also known as the gross profit margin or the gross profit percentage.

The gross margin ratio is computed by dividing the company's gross profit dollars by its net sales dollars. A company should be continuously monitoring its gross margin ratio to be certain it will result in a gross profit that will be sufficient to cover its selling and administrative expenses.

Since gross margin ratios vary between industries, you should compare your company's gross margin ratio to companies within your industry. However, you should keep in mind that there can also be differences within your industry. Perhaps your company focuses its sales efforts on smaller customers who also require special administrative services. In that case, your company's gross margin ratio should be larger than your industry's in order to cover the higher selling and administrative expenses.

Question 4. Answer : Vertical analysis reports each amount on a financial statement as a percentage of another item. For example, the vertical analysis of the balance sheet means every amount on the balance sheet is restated to be a percentage of total assets.

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