A characteristic of the payback method (before taxes) is that it
Answer (B) is correct.
The payback method calculates the number of years required to complete the return of the original investment. This measure is computed by dividing the net investment required by the average expected cash flow to be generated, resulting in the number of years required to recover the original investment. Payback is easy to calculate but has two principal problems: It ignores the time value of money, and it gives no consideration to returns after the payback period. Thus, it ignores total project profitability.
The length of time required to recover the initial cash outlay of a capital project is determined by using the
Answer (B) is correct. The payback method measures the number of years required to complete the return of the original investment. This measure is computed by dividing the net investment by the average expected cash inflows to be generated, resulting in the number of years required to recover the original investment. The payback method gives no consideration to the time value of money, and there is no consideration of returns after the payback period.
Which one of the following statements about the payback method of investment analysis is correct? The payback method
Answer (A) is correct. The payback method calculates the amount of time required to complete the return of the original investment, i.e., the time it takes for a new asset to pay for itself. Although the payback method is easy to calculate, it has inherent problems. The time value of money and returns after the payback period are not considered.
The payback reciprocal can be used to approximate a project’s
Answer (D) is correct. The payback reciprocal (1 ÷ payback) has been shown to approximate the internal rate of return (IRR) when the periodic cash flows are equal and the life of the project is at least twice the payback period.
The bailout payback method
Answer (D) is correct. The payback period equals the net investment divided by the average expected cash flow, resulting in the number of years required to recover the original investment. The bailout payback incorporates the salvage value of the asset into the calculation. It determines the length of the payback period when the periodic cash inflows are combined with the salvage value. Hence, the method measures risk. The longer the payback period, the more risky the investment.
Whatney Co. is considering the acquisition of a new, more efficient press. The cost of the press is $360,000, and the press has an estimated 6-year life with zero salvage value. Whatney uses straight-line depreciation for both financial reporting and income tax reporting purposes and has a 40% corporate income tax rate. In evaluating equipment acquisitions of this type, Whatney uses a goal of a 4-year payback period. To meet Whatney’s desired payback period the press must produce a minimum annual before-tax operating cash savings of
Answer (B) is correct.
Payback is the number of years required to complete the return of the original investment. Given a periodic constant cash flow, the payback period equals net investment divided by the constant expected periodic after-tax cash flow. The desired payback period is 4 years, so the constant after-tax annual cash flow must be $90,000 ($360,000 ÷ 4). Assuming that the company has sufficient other income to permit realization of the full tax savings, depreciation of the machine will shield $60,000 ($360,000 ÷ 6) of income from taxation each year, an after-tax cash savings of $24,000 ($60,000 × 40%). Thus, the machine must generate an additional $66,000 ($90,000 – $24,000) of after-tax cash savings from operations. This amount is equivalent to $110,000 [$66,000 ÷ (1.0 – .4)] of before-tax operating cash savings.
The Dickins Corporation is considering the acquisition of a new machine at a cost of $180,000. Transporting the machine to Dickins’ plant will cost $12000 . Installing the machine will cost an additional $18,000. It has a 10-year life and is expected to have a salvage value of $10,000. Furthermore, the machine is expected to produce 4,000 units per year with a selling price of $500 and combined direct materials and direct labor costs of $450 per unit. Federal tax regulations permit machines of this type to be depreciated using the straight-line method over 5 years with no estimated salvage value. Dickins has a marginal tax rate of 40%.
What is the approximate payback period on Dickins’ new machine?
Answer (B) is correct. The company will receive net cash inflows of $50 per unit ($500 selling price – $450 variable costs), a total of $200,000 per year for 4,000 units. This amount will be subject to taxation. However, for the first 5 years, a depreciation deduction of $42,000 per year ($210,000 ÷ 5 years) will be available. Thus, annual taxable income will be $158,000 ($200,000 – $42,000). At a 40% tax rate, income tax expense will be $63,200, and the net cash inflow will be $136,800 ($200,000 – $63,200). When annual cash inflows are uniform, the payback period is calculated by dividing the initial investment ($210,000) by the annual net cash inflows ($136,800). Dividing $210,000 by $136,800 produces a payback period of 1.54 years.
Fitzgerald Company is planning to acquire a $250,000 machine that will provide increased
efficiencies, thereby reducing annual operating costs by $80,000. The machine will be depreciated by the straight-line method over a 5-year life with no salvage value at the end of 5 years. Assuming a 40% income tax rate the machine’s payback period is
Answer (C) is correct. The payback period is the number of years required to complete the return of the original investment. This measure is computed by dividing the net investment required by the average expected net cash inflow to be generated. The first step is to determine the annual cash flow. The $80,000 cost reduction will be offset by the tax expense on the savings. The full $80,000, however, will not be taxable because depreciation can be deducted before computing income taxes. Allocating the $250,000 cost evenly over 5 years produces an annual depreciation expense of $50,000. Thus, taxable income will be $30,000 ($80,000 – $50,000). At a 40% tax rate, the tax on $30,000 is $12,000. The net annual cash inflow is therefore $68,000 ($80,000 – $12,000), and the payback period is 3.68 years ($250,000 investment ÷ $68000.
When ranking two mutually exclusive investments with different initial amounts, management should give first priority to the project
Answer (D) is correct. The profitability index (excess present value index) facilitates the comparison of investments that have different initial costs. The profitability index is the ratio of the present value of the future net cash flows (or only cash inflows) to the net initial investment. The investment with the greater profitability index will be the preferred investment.
The bailout payback method
Answer (B) is correct. The bailout payback period is the length of time required for the sum of the cumulative net cash inflow from an investment and its salvage value to equal the original investment. The bailout payback method measures the risk to the investor if the investment must be abandoned. The shorter the period, the lower the risk.