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  • 1.  Payback period

    Posted 02-17-2020 05:54 AM
    Dear All, 

    Why is pre-tax cashflow considered for the calculation below instead of the after-tax given in the problem?

    Study Unit 9Investment Decisions | Subunit 4Payback and Discounted Payback

     
     
    Question: 44A company is planning to purchase a new machine that will cost $450,000 with delivery and setup costs of $50,000. The machine will be depreciated using the straight-line method over 5 years with a zero salvage value at the end. It is expected that the machine will help the company generate additional after-tax net revenues of $180,000 annually. The company is subject to a 20% income tax rate. The machine payback period is
    Answer (C) is correct.
    The traditional payback period is the number of years required to return the original investment. There is no discount for the time value of money. If the cash flows are constant, the formula is Payback = Initial investment ÷ Annual cash flows. The initial investment is $500,000 ($450,000 + $50,000). Dividing the $500,000 by the annual cash flows of $200,000 results in a payback of 2.5 years. The annual cash flows of $200,000 are calculated by subtracting the income tax expense from the cash flows from operations. The cash flows from operations also have to be calculated since the question gives only the after-tax net revenues. Taxes are calculated as follows: Tax = (Before-tax profit – Depreciation) × .2, while Before-tax profit – Tax = $180,000. Combining the two equations yields BTP – [(BTP – 100,000) × .2] = $180,000, or .8BTP + 20,000 = $180,000, or .8BTP = $160,000. Therefore, BTP = $200,000.




  • 2.  RE: Payback period

    Posted 02-18-2020 02:29 AM
    As you know, to find out Payback, denominator would be "after tax cash flow".

    But in the question, he gave after tax revenue, But we need "after tax cash flow" and do following calculation,

    Before tax revenue = 180,000/0.8 = $225,000

    Denominator Calculation:

    Revenue                               225,000
    Minus - Depreciation           (100,000)
    Cash Flow                            125,000
    Tax (20%)                              (25,000)
    Net of Tax                             100,000     (125,000*0.8)
    Add back depreciation          100,000
    After Tax CF                         200,000

    And you the answer would be 2.5Y


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    Zubair
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  • 3.  RE: Payback period

    Posted 02-18-2020 02:32 AM
    While calculating the payback period, you have to remember that it is always calculated on the basis of cash flow and not the net profit. To calculate the cash flow, we have to add back depreciation tax shield to the net profit/revenue. The short cut way of calculating in the exam is shown below.

    Tax shield on depreciation = 0.20*100000 = 20000
    Annual cash flow = 180000 + 20000 = 200000
    Payback period = 500000 / 200000 = 2.5

    Let me know if you need more clarification.

    Kind Regards,
    Ayaz Mohammed

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    Ayaz Mohammed Anees Shaikh
    Finance Manager
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  • 4.  RE: Payback period

    Posted 02-18-2020 03:09 AM
    Hi Shilpa,
    The $500,000 expended for the capital project was expended before taxes.

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    Ronald Thomas
    Fixed Assets Accountant
    Bristol, PA, US
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  • 5.  RE: Payback period

    Posted 02-18-2020 03:30 AM
    It is not pre tax. $180k is AFTER-TAX net inflow. Plus we have Dep Tax Shield of $20k. Total $200k. 

    Payback Period = $500k/$200k
    = 2.5 yrs