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Calculation of Payback Period for Investor Return

Executive Summary

The report exclusively deals with the Accounting and Financial Management. The report has been divided into two broad types. The first part deals with the calculations regarding the payback period, average accounting return and break-even analysis. This part of the report also explains the various aspects of the same. The next half of the report is based on the calculations related with the Horizontal and vertical analysis. Further, it also explains the different patterns and trends present in the Income Statement and Balance Sheet based on the calculations done.

Introduction

The primary objective of accounting in any business is to help that business make the maximum profit after tax. Unless accounting makes its full contribution to that objective, its cost cannot be justified. In today’s industry, one of the ways accounting pays for itself is to help management to control operations. Another way is to help management utilize its working capital to the greatest possible advantage.

Every business has important financial concerns and its success or failure depends in a large part on the quality of its financial decisions. Effective financial decision making requires an understanding of the goal(s) of the firm. The widely accepted objective of the firm is to maximize the value of firm for its owners, i.e. to maximize shareholders wealth (MAYER, R. et al, 2005).

Hence, the accounting and financial management has become an integral part of business in the twenty-first century. The concept of payback period, average accounting return, breakeven analysis, trend analysis and vertical analysis are very important for any business, big or small.

Discussion

2.1 Problem 1

A company is considering a capital project costing £ 400,000. The sales forecasts, together with the forecast expenditure are shown below:

Table 1: Sales and Expenditure Forecast

Year Sales (£) Cost of Sales (£) Other variable costs (£) Fixed costs except depreciation (£) Depreciation (£)
1 200,000 60,000 20,000 30,000 100,000
2 300,000 90,000 30,000 30,000 100,000
3 400,000 120,000 40,000 30,000 100,000
4 300,000 90,000 30,000 30,000 100,000
1,200,000 360,000 120,000 120,000 400,000

The above problem can be formulated in the form of Income Statement as below:

Table 2: Income Statement of the Company

Years 1 2 3 4
Sales 200,000 300,000 400,000 300,000
Cost of Sales (60,000) (90,000) (120,000) (90,000)
Gross Profit: 140,000 210,000 280,000 210,000
Variable Cost (20,000) (30,000) (40,000) (30,000)
Earnings before Fixed Charges: 120,000 180,000 240,000 180,000
Fixed Cost (30,000) (30,000) (30,000) (30,000)
Earnings before tax and depreciation: 90,000 150,000 210,000 150,000
Depreciation (100,000) (100,000) (100,000) (100,000)
Net Income: -10,000 50,000 110,000 50,000

2.1.1 Calculation of Payback period for the Project

The payback period for the project is the length of time to get your money back (FABOZZI and PETERSON, 2003). In this problem, the company has invested £ 400,000.

The table below shows the expected cash flows in the four years:

Table 3: Expected Cash Flows of the Company

End of Year Expected Cash Flows Accumulated Cash Flows
1 90,000 90,000
2 150,000 240,000
3 210,000 450,000
4 150,000 600,000

From the table above, it is clear that at the end of Year 2, the full £400,000 will not be paid back. We need to have some amount from Year 3 as well. The amount needed from Year 4 will be £400,000 – 240,000 = £160,000.

Hence, the payback period is calculated as:

Payback Period: 2 years + 160,000/210,000 = 2.762 years
= 2 years and 9 months (Approx.)

Thus, the Payback period for the company is 2 years and 9 months.

Calculation of the Average Accounting Return

The Average Accounting Return (AAR) measures the return on an investment, after taxes and depreciation, over a specified period. Mathematically, the ratio is equivalent to the expected average earnings less taxes and depreciation, divided by the average book value over the duration of the investment.

According to table 2 above, we need to find the values of:

  • Average project earning after tax and depreciation

Average Net Income = Sum of all Net Incomes / No. Of Years

= (-10,000 + 50,000 + 110,000 + 50,000) / 5

= £ 50,000

  • Average book value of the investment during its life time

The depreciation for each year is £ 100,000. Thus, the yearly book value of investment is given by:

Table 4: Book Values

Year Book Value
1 400,000
2 300,000
3 200,000
4 100,000
5 0

Average book value = Sum of all book values / No. Of years

= 400,000 + 300,000 + 200,000 + 100,000 + 0 / 5

= £ 200,000

Average Accounting Return (AAR) = 50,000 / 200,000

= 0.25

Therefore, the Average Accounting Return for the invested £ 400,000 after taxes and depreciation is 25 %.

Break-Even Analysis for the Project

One of the most common tools used in evaluating the economic feasibility of a new enterprise or product is the break-even analysis. The break-even point is the point at which revenue is exactly equal to costs (HOLLAND, 1998). At this point, no profit is made and no losses are incurred. The break-even point can be expressed in terms of unit sales or pound sales.

That is, the break-even units indicate the level of sales that are required to cover costs. Sales above that number result in profit and sales below that number result in a loss. The break-even sales indicate the pound of gross sales required to break-even. So, a break-even cannot be calculated only once. It should be calculated on a regular basis to reflect changes in costs and prices and in order to maintain profitability or make adjustments in the product line. 1

Break-even (Sales) = Total Fixed Cost / (1- Total Variable Cost / Sales)

For Year 1,

BEP (Sales) = 130,000 / (1- 80,000 / 200,000)

= £ 216,666.67

For the Year 2, 3 and 4 also same BEP (Sales) value came due to proportionate change in total fixed cost, total variable cost and sales.

This figure is the level of sales that the company must reach in order to break even. Again, if the company is reaching more than this, then it should be making a profit and if it is not, the company will not be selling enough to cover the fixed expenses.

Thus, no profits are made from the sale of product until more than £ 216,666.67 in gross sales is generated.

____________________

Source: 1, HODGETTS & KURATKO,1986.

As sales increases, variable costs are incurred, meaning that total costs (fixed + variable) also increase. At low levels of output, costs are greater than income. At the point of intersection (total sales and total cost intersection), costs are exactly equal to income, and hence neither profit nor loss made. This point of intersection is called the Break-even point which is found to be £ 216,666.67.

In the first year, the total sale made by the company is £ 200,000. But BEP (Sales) is found to be £ 216,666.67. That means, the company is still short of £ 16,666.67 in order to make neither profit nor loss i.e. BEP.

In the second year, the total sale made by the company is £300,000. Compared to the BEP (Sales) which is £ 216,666.67; the company is now making profit. And it continues to do that for year 3 and 4 as well.

Thus, break-even analysis helps a company to maintain profitability when costs and prices changes.

2.2 Problem 2

The Horizontal and vertical analyses on financial statements of the Geneva Palace Hotel are as follows:

Table 5: Income Statement (Horizontal Analysis)

Income Statement
Geneva Palace Hotel
For the Years Ending 31 December 2005, 2006 and 2008
2005 % ( 2005-2006) 2006 % (2006-2007) 2007
Food Sales Revenue £ 1,700,500 5.26 £ 1,790,000 4.00 £ 1,861,600
Cost of Goods Sold 471,128 6.38 501,200 8.00 541,296
Gross Profit 1,229,372 4.83 1,288,800 2.44 1,320,304
Operating Expenses
Salaries and Wages 541,654 12.36 608,600 9.00 663,374
Employee Benefits 63,008 13.64 71,600 11.00 79,476
Laundry Expenses 17,005 5.26 17,900 3.50 18,527
Supplies Expenses 52,089 3.09 53,700 3.50 55,580
Advertising 16,826 6.38 17,900 6.00 18,974
Utilities 36,860 3.09 38,000 1.50 38,570
Maintenance 16,910 12.36 19,000 10.00 20,900
Other Expenses 38,800 3.09 40,000 1.50 40,600
Total Operating Expenses 783,152 10.67 866,700 8.00 936,001
Income Before Fixed Charges 446,220 -5.41 422,100 -8.95 384,303
Fixed Charges
Rent 19,400 3.09 20,000 4.00 20,800
Property Taxes 9,400 6.38 10,000 5.00 10,500
Insurance 4,250 17.65 5,000 20.00 6,000
Interest 76,000 5.26 80,000 4.00 83,200
Depreciation 19,200 4.17 20,000 4.00 20,800
Total Fixed Charges 128,250 5.26 135,000 4.67 141,300
Inc

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