Calculation of Payback Period for Investor Return
Info: 5118 words (20 pages) Dissertation
Published: 11th Dec 2019
Tags: AccountingFinance
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 breakeven 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 twentyfirst 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 %.
BreakEven Analysis for the Project
One of the most common tools used in evaluating the economic feasibility of a new enterprise or product is the breakeven analysis. The breakeven 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 breakeven point can be expressed in terms of unit sales or pound sales.
That is, the breakeven 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 breakeven sales indicate the pound of gross sales required to breakeven. So, a breakeven 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}
Breakeven (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 Breakeven 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, breakeven 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 
% ( 20052006) 
2006 
% (20062007) 
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 
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