Homework SourseIs the overhaul costs suppose to be accounted for when calcu
Is the overhaul costs suppose to be accounted for when calculating the payback period???
Step-1: Calculation of payback period:
Particulars
Alternative-A (in $)
Alternative-B (in $)
Alternative-C (in $)
Initial Investment
Cost
10,00,000
12,50,000
20,00,000
Setup Cost
0
50,000
50,000
Training cost
10,000
25,000
35,000
Total Initial Investment
10,10,000
13,25,000
20,85,000
Net Annual Cash Inflows
Annual savings
1,25,000
1,90,000
2,25,000
Annual Labor Savingd
25,000
0
40,000
Total savings (A)
1,50,000
1,90,000
2,65,000
Annual maintenance cost (B)
10,000
15,000
16,000
Net Annual Cash Inflows (A)-(B)
1,40,000
1,75,000
2,49,000
Payback Period
=Net investment/Annual Cash flow
7.21
7.57
8.37
Ranking
1
2
3
Step-2: Calculation of Net Present value
Particulars
Alternative-A (in $)
Alternative-B (in $)
Alternative-C (in $)
Initial Cash Outflow (Step-1)
10,10,000
13,25,000
20,85,000
Overahall expesnes in 4th year
45,000
50,000
35,000
PVF @ 12%
0.636
0.636
0.636
PV of ovehall expenses
28,620
31,800
22,260
PV of total cash outflows
10,38,620
13,56,000
21,07,260
PV of Net cash Inflows
Net Annual Cash Inflows (Step-1) (A)
1,40,000
1,75,000
2,49,000
No of Years
8
8
7
PVAF @12% (B)
4.967
4.967
4.564
PV of cash in flows (A)*(B)
6,95,380
8,69,225
11,36,436
Net Present value=PV of cash inflows-PV of cash outflows
(3,43,240)
(4,86,775)
(9,70,824)
Ranking
1
2
3
Step-3: Calculation of Accounting rate of return:
Particulars
Alternative-A (in $)
Alternative-B (in $)
Alternative-C (in $)
Average Annual Profit:
Annual Cash Inflows
1,40,000
1,75,000
2,49,000
No of Years
8
9
7
Total Inflow over period
11,20,000
15,75,000
17,43,000
Less: Overhaul cost
45,000
50,000
35,000
Less: Depreciation
(No salvage value)
10,10,000
13,25,000
20,85,000
Total Profit/(loss) of project
65,000
2,00,000
(3,77,000)
Useful life
8
9
7
Average Annual Profit
8125
22,222
Nil
Average Investment
Initial Investment
10,10,000
13,25,000
20,85,000
At the end salvage value
0
0
0
Average Investment=(initial investment+ At the end salvage value)/2
5,05,000
6,62,500
10,42,500
Accounting rate of return=Average Annual Profit/Average investment
1.6%
3.35%
O%
Ranking
2
1
3
Step-4: Internal Rate of Return:
Particulars
Alternative-A (in $)
Alternative-B (in $)
Alternative-C (in $)
NPV @ 10%
Initial Outflows
10,10,000
13,25,000
20,85,000
Overhall expense at the end of 4th year
45,000
50,000
35,000
PVF @10%
.683
0.683
0.683
PV of Overhall expense
30,735
34,150
23,905
Total Initial outflows
10,40,735
13,59,150
21,08,905
Net annual cash flows
1,40,000
1,75,000
2,49,000
Annuity factor@10%
5.3349
5.7590
4.8684
Annuity cashflows
7,46,886
1007825
12,12231
NPV @10%
(293849)
(351325)
(8,96,674)
NPV @12%
(3,43,240)
(4,86,775)
(9,70,824)
IRR=10%+NPV1*(R2-R1)/(NPV1-NPV2)
10.93%
10.83%
10.96%
Ranking
2
3
1
Step-5: Analysis Table (Ranking Table)
Particular
Alternative-A
Alternative-B
Alternative-C
Payback Period
1
2
3
NPV
1
2
3
Accounting rate of return
2
1
3
Internal Rate of return
2
3
1
| Alternative A | Alternative B | Alternative C | |
| Cost | $1,000,000 | $1,250,000 | $2,000,000 |
| Setup Costs | $0 | $50,000 | $50,000 |
| Training costs | $10,000 | $25,000 | $35,000 |
| Annual maintence costs | $10,000 | $15,000 | $16,000 |
| Anticipated annual savings | $125,000 | $190,000 | $225,000 |
| Annual labor savings | $25,000 | $0 | $40,000 |
| Expected useful life in years | 8 | 9 | 7 |
| Overhaul costs in year 4 | $45,000 | $50,000 | $35,000 |
Solution
Yes, all relevant expenses are to be considered for computation of payback period.
Payback period represents the period within which the initial investment would be recovered. Since there are overhaul expenses in year 4, it implies that there is a cash outflow which does not allow the initial investment to be recovered.
For computing the payback period, the annual cash flows should be calculated which would be lesser in year 4 due to overhaul expenses. The cash flows are then cumulated to analyse the period in which the initial investment is completely recovered. Hence overhaul costs should be considered.
