Question

Raysut Cement Ltd. envisages purchase of a machine to augment the company’s prodcution capacity to meet the forecasted sales demand for its product’s. There are two machines under consideration of the management. The relevant details of estimated annual expenditure and sales are given below: The company pays tax @ of 30%.

	Machine 1	Machine 2
	$	$
Cost of Machine	200,000	150,000
Estimated Annual Sales	300,000	240,000
Cost of production (estimated)
Direct Materials	50,000	30,000
Direct Labour	40,000	50,000
Production Costs	60,000	50,000
Administration Costs	20,000	10,000
Sales Promotion	10,000	10,000

The useful life of Machine 1 is 2 years, while it is 3 years for machine 2. The scrap values are $20,000 and $15,000 respectively.

a)     Calculate the ‘Pay Back Method’ for both the machines.

b)     Comment on your calculations in 'a' above.

Answer 1

Requirement A:-

Step 1:- Calculate the cash inflows/outflows for the machines

Particulars	Machine 1	Machine 2
Sales	300,000	240,000
Less:-Expenses
Direct Materials	(50,000)	(30,000)
Direct Labor	(40,000)	(50,000)
Production costs	(60,000)	(50,000)
Administration costs	(20,000)	(10,000)
Sales promotion	(10,000)	(10,000)
Depreciation	(90,000)	(45,000)
Total expenses	(270,000)	(195,000)
Income before taxes	30,000	45,000
Income tax (@30%)	(9,000)	(13,500)
Net Income	21,000	31,500
Add:- Depreciation	90,000	45,000
Annual Cash flows	111,000	76,500

Note that we add back the Depreciation expenses because it is a Non cash expense and so we adjust it to find the actual cash inflows.

The Depreciation expenses for Machine 1 and Machine 2 is calculated as follows(Note that we have used the Straight line method of depreciation in our considerations)

Depreciation expense = (Cost of the asset - Salvage value)/Estimated life of the asset

Machine 1 = ($200,000 - $20,000)/2 = $90,000 per year

Machine 2 = ($150,000 - $15,000)/3 = $45,000 per year

Step 2:- Calculate the payback period

Payback period = Initial Investments/Estimated annual cash flows

Machine 1 = $200,000/$111,000 = 1.80 years

Machine 2 = $150,000/$76,500 = 1.96 years

Requirement B:-

Based on the calculations performed above, Machine 1 has a payback period of 1.80 years while the Machine 2 has a payback period of 1.96 years. The Payback period is a calculation of the company's ability to recover its cost of investment. The lower the payback period , the better it is for the company as the company would be able to realize the recover the funds it invested early. As such, the company should consider investing in Machine 1 since it has a lower payback period.