Question Tag: Payback Period

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  • 30 Marks

FM – Nov 2020 – L3 – Q1 – International Financial Management

Evaluates a foreign investment project in Linder, with NPV, payback period, and real options for abandonment analyzed under two scenarios.

Assume today is November 20, 2019. In 2018, the Oyin Division of Aba plc successfully launched a new premium wine, “Aladun,” in Nigeria. The Divisional Board of Oyin Division is now considering plans put forward by the Divisional Marketing Manager to launch the full range of Aladun in another country, “Linder.” Linder has the Linderian dollar (L$) as its currency, and the launch is planned for January 1, 2020.

It is known that breaking into the Linderian market for fruit wine is challenging due to strong local brand loyalty. Initial market research based on free tasting sessions has been promising, though uncertainties remain. The biggest risk identified is the potential for a Nigerian competitor to enter the same market with a similar product.

Financial Data for the Project:

  • Initial market research for the Linderian market: N5 million (already spent).
  • Additional detailed market research and packaging design (if approved): N20 million.
  • Launch campaign (radio and TV advertising): N10 million.
  • Distribution center in Linder: L$84 million.

Operating cash flow forecasts for the year ending December 31, 2020, vary based on two scenarios:

  • Scenario A: Sales revenue L$100 million; costs L$10 million + N20 million.
  • Scenario B: Sales revenue L$55 million; costs L$10 million + N15 million.
  • Probability of occurrence: 70% for Scenario A, 30% for Scenario B.

Other relevant financial data:

  • Oyin Division’s project evaluation discount rate: 15%.
  • Project duration: 4 years.
  • Expected operating cash flow growth: 5% per year.
  • Residual value of the distribution center: L$52 million after 4 years.
  • Exchange rate: N1 = L$1.2000 on January 1, 2020 (strengthening by 2% per year).
  • Corporate tax rate in Nigeria: 35%.
  • Tax allowances on capital expenditure: 100% (tax-deductible in Nigeria).

Additional Option:

  • The project could be abandoned on January 1, 2021, with the distribution center sold for an estimated L$70 million if Scenario B occurs.

Required:

a. Ignoring the abandonment option: i. Calculate the NPV for the project as of January 1, 2020, for each scenario and the overall total expected NPV. (17 Marks) ii. Calculate the payback period for each scenario. (4 Marks) iii. Interpret your results. (4 Marks)

b. Evaluate the abandonment decision on January 1, 2021, if Scenario B occurs. (7 Marks)

c. Advise on how real options and other strategic financial issues may influence the investment decision. (8 Marks)

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  • 30 Marks

PM – Nov 2015 – L2 – Q1 – Decision-Making Techniques

Comparison of two machine purchase options - ZIGMA 5000 and DELPHA 7000 using profitability statement, cash flows, payback period and NPV.

The Board of Directors of Danda Company Limited is proposing the purchase of either of two machines that have been proved adequate for the production of an engineering product “Gee”. The two machines are: ZIGMA 5,000 and DELPHA 7,000. Production in the first year would be affected by installation challenges and inadequate understanding of the operating instructions of the machines.

Information available from the production profile of the two machines are as shown below:

ZIGMA 5000:

Cost of machine is N16,500,000 while the life span is 6 years.

DELPHA 7000:

Cost of plant is N18,300,000 while the life span is 6 years.

Other information relevant to the company’s operations and administration are:

(i) Selling price per unit is N300.

(ii) Variable cost per unit is N150.

(iii) Annual fixed overhead exclusive of depreciation is N1,200,000.

(iv) Company depreciation policy is straight line basis.

(v) The budgeted production capacity is 100,000 units.

(vi) No opening or closing inventory is envisaged.

(vii) All sales are for cash.

(viii) All costs are for cash.

Required:

a. Prepare the SIX year profitability statement for the two machines. (6 Marks)

b. Prepare the SIX year cash flow statement for the two machines. (6 Marks)

c. What is the payback period for the two machines? (7 Marks)

d. Determine the Net Present Value (NPV) of the two machines if the acceptable discount rate for the company is 15%. (7 Marks)

e. Which of the two machines should the company acquire? (4 Marks)

 

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  • 20 Marks

BMF – May 2015 – L1 – SB – Q4 – Basics of Business Finance and Financial Markets

Discuss major cash flow items in capital investment projects and explain the payback period investment appraisal method.

a. List and explain FOUR major cashflow items to be included in a capital investment project. (8 Marks)
b.
i. Explain the payback period technique of investment appraisal. (4 Marks)
ii. State TWO advantages and TWO disadvantages of payback period. (8 Marks)

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  • 22 Marks

PSAF – Nov 2018 – L2 – Q4 – Government Accounting Concepts and Principles

Evaluate the viability of two local government projects using Pay Back Period and Accounting Rate of Return methods.

Sampolopolo Local Government has identified a vacant land beside its marriage registry building. The director of administration proposed that the land be used either for a cybercafé where the general public can browse, make phone calls, photocopy and carry out other computer services or for the construction of an entertainment event-hall that can be rented out on a commercial basis.
This idea was tabled at the council’s management meeting and unanimously accepted. However, the Finance and General Purposes Committee recommended five years for the project since the council secretariat building will be extended in the future to accommodate more offices for the increased staff strength, and this was approved.

The cost of building the cybercafé and the event-hall with necessary facilities and fittings as well as the expected cash inflows/profits as prepared by the director of administration are as follows:

Required:
As the consultant engaged by Sampolopolo Local Government, advise the Local Government on the more viable project using:
i. Pay Back Period (PBP) (7 Marks)
ii. Accounting Rate of Return (ARR) (13 Marks)

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  • 20 Marks

BMF – May 2021 – L1 – SB – Q3 – Investment Decisions

Calculate payback periods for two investment projects and decide based on company policy.

CASHIO Limited must choose between two investments, Project ABUWA and Project BRIWA. It cannot undertake both investments. The expected cash flows for each project are:

Year Project ABUWA (₦) Project BRIWA (₦)
0 (800,000) (800,000)
1 200,000 600,000
2 360,000 240,000
3 360,000 20,000
4 170,000 –

The company has a policy that the maximum permissible payback period for an investment is three years and if a choice has to be made between the two projects, the project with the earlier payback will be chosen.

a. Calculate the payback period for each project:
i. Assuming that cash flows occur at year-end
ii. Assuming that cash flows after Year 0 occur at a constant rate throughout each year (16 Marks)

b. Which project should be selected according to the company’s payback rule? (2 Marks)

c. State the reasons for your decision in (b) above. (2 Marks)

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  • 1 Marks

BMF – Nov 2023 – L1 – SA – Q6 – Investment Decisions

Identify the incorrect feature of the payback period appraisal method.

Which of the following features is INCORRECT in respect of the payback period investment appraisal method?

A. It can be used to eliminate projects that will take too long to pay back
B. Often used by companies that have liquidity problems
C. Ignores the total cash returns from the project
D. Analyses accounting profits
E. Simple to calculate

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  • 20 Marks

BMF – Nov 2019 – L1 – SB – Q6 – Investment Decisions

State decision rules for ARR and Payback Period and appraise a project using NPV.

(a) State the decision rules of the following investment appraisal techniques:

i. Accounting rate of return (2 Marks)
ii. Payback period (3 Marks)

(b) Fatfelic Ltd is considering a project with the following cash flows:

Year Cost of Plant (N) Running Costs (N) Savings (N)
2020 (1,280,000)
2021 480,000 840,000
2022 550,000 980,000
2023 670,000 1,120,000
2024 890,000 1,400,000

Fatfelic Ltd’s cost of capital is 10%.

Required:
i. Appraise the viability of the proposed project using the Net Present Value (NPV) method of investment appraisal.
ii. State with reasons if the project is worthwhile. (15 Marks)

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  • 15 Marks

MA – Nov 2019 – L2 – Q4a – Introduction to capital budgeting

Select the appropriate plant for Pagsana Company using Payback Period and NPV analysis.

a) Pagsana Company plans to introduce a new product line for production of its local drink in Walewale. The company, therefore, decided to acquire either a semi-automated plant or an automated plant. The relevant data for the two proposed plants are as follows:

Required:
i) Select the appropriate plant on the basis of:

  • Payback Period (4 marks)
  • Net Present Value

(7 marks)

ii) Explain TWO (2) advantages of discounted cashflow method of investment appraisal. (4 marks)

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  • 15 Marks

MA – Mar 2024 – L2 – Q4a – Decision making techniques

This question evaluates two investment proposals using the payback period method and addresses factors affecting the reliability of cash flows.

The following mutually exclusive investment opportunities are being proposed to Kwame, who wants reliable cash receipts on an annual basis:

Proposal A:

Purchase of a commercial vehicle at the cost of GH¢90,000 that will generate weekly sales of GH¢800. The owner will incur the following annual expenses on the vehicle:

Expenses GH¢
Insurance 1,200
Tyres 10,400
Roadworthy 1,400
Routine maintenance 9,000

Note: Assume 52 weeks in a year.

Proposal B:

The repair of an unoccupied two-bedroom flat at the cost of GH¢90,000. The flat was bought by Kwame for GH¢650,000 three years ago. The monthly rental will be GH¢1,450 subject to 8% rent tax. The owner will also pay property tax of GH¢1,200 per year.

Required:
i) Advise Kwame which of the proposals is acceptable using the payback period method of investment appraisal. (8 marks)
ii) Explain TWO (2) factors that can affect the reliability of the cash flow of the transport business. (2 marks)
iii) State TWO (2) qualitative factors that may influence the decision to opt for proposal B. (2 marks)
iv) Explain TWO (2) reasons the NPV may be a better appraisal technique than the payback period. (3 marks)

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  • 15 Marks

MA – July 2023 – L2 – Q4a – Discounted cash flow

Calculate the cost of capital for a delivery van investment using IRR, and compare payback and discounted cash flow methods of investment appraisal.

a) Johnson & Co is a medium sized company that is engaged in delivery services. As a result
of the recent increase in the demand for services, the Managing Director (MD) is planning
for the future business performance. The MD plans to acquire a delivery van at the cost of
GH¢85,000. The expected net cash flow per year are as follows:

The Sales Manager has indicated to the MD that he will recoup his investment in less than four years and for that reason, it’s a good investment.

The Management Accountant has however drawn his attention to the fact that the manager has not factored time value of money and the cost of capital in his analysis. He could not however suggest the cost of capital since financial institutions are charging different interest rates.

Required:

i) Calculate the cost of capital when used would result in a break-even, when the useful life of the van is five years with residual value of GH¢8,500. (11 marks)

ii) Using TWO (2) points each, compare and contrast the payback method of investment appraisal and the discounted cash flow method.

(4 marks)

 

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  • 12 Marks

MA – Nov 2021 – L2 – Q4a – Discounted Cash Flow

Calculate and evaluate the payback period for the Ohenewa project based on provided cash flows.

a) Bee Ltd manufactures high-quality mobile phones for its local market. Due to less competition, Bee Ltd sales have grown significantly over the past few years and are expected to grow. Bee Ltd is planning to launch a new model, ‘Ohenewa’.

The company has already spent GH¢1 million on Research and Development and will require a further investment of GH¢5.5 million in production equipment. This cost excludes the GH¢1.1 million installation fee. The project has a life span of five years. In the end, the equipment will have a residual value of GH¢0.6 million. Sales and production of Ohenewa over its lifecycle are expected to be:

Year Units
1 6,500
2 7,500
3 8,000
4 7,800
5 7,000

The selling price in Year 1 and Year 2 will be GH¢750 per unit. However, the selling price will be reduced to GH¢600 per unit in Year 3 and will remain at this level for the remainder of the project. The variable cost as a percentage of sales is 55% over the entire product lifecycle. The fixed overhead, including depreciation cost expected to be incurred directly due to increasing the production capacity, is GH¢2 million per annum.

Other information:

  • A cost of capital of 12% per annum is used to evaluate projects of this type.
  • Bee Ltd has a history of accepting similar projects which pay back within three years.
  • Ignore inflation and taxation.

Required:
i) Calculate the Payback Period for the Ohenewa project. (10 marks)
ii) Evaluate the acceptability of the project based on the calculation in i) above. (2 marks)

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  • 7 Marks

MA – May 2016 – L2 – Q2a – Discounted Cash Flow, Decision Making Techniques

Discuss the justifications for the popularity and limitations of Payback Period and ARR as investment appraisal techniques.

It is said that of all the capital investment evaluation approaches, the Payback (PB) and Accounting Rate of Return (ARR) methods are widely used in practice. But these methods are not without limitations.

Required:

i) State TWO justifications of Payback Period and ONE justification of ARR for their popularity in practice as investment appraisal techniques.
(3 marks)

ii) Outline TWO limitations each for Payback Period and ARR as investment appraisal techniques.
(4 marks)

 

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  • 20 Marks

FM – May 2020 – L2 – Q4 – Discounted cash flow | Introduction to Investment Appraisal

Calculate the NPV and payback periods for a project, and explain concepts related to market volatility and bull/bear markets.

Sabir Company is considering whether to invest in a project whose details are as follows.
The project will involve the purchase of equipment costing GH¢2,000,000. The equipment will be used to produce a range of products for which the following estimates have been made.

Incremental fixed costs are GH¢1,200,000 per annum. The sales prices allow for expected price increases over the period. However, cost estimates are based on current costs and do not allow for expected inflation in costs. Inflation is expected to be 3% per year for variable costs and 4% per year for fixed costs. The incremental fixed costs are all cash expenditure items. Tax on profits is at the rate of 30%, and tax is payable in the same year in which the liability arises.

Sabir Company uses a four-year project appraisal period, but it is expected that the equipment will continue to be operational and in use for several years after the end of the first four-year period.

The company’s cost of capital for investment appraisal purposes is 10%. Capital projects are expected to pay back within two years on a non-discounted basis and within three years on a discounted basis. Tax allowable depreciation will be available on the equipment at the rate of 25% per year on a reducing balance basis. Any balancing allowance or balancing charge is not attributed to a project unless the asset is actually disposed of at the end of the project period.

Required:

a) Calculate the net present value (NPV) of the project.
(11 marks)

b) To the nearest month, calculate the non-discounted payback period and the discounted payback period.
(4 marks)

c) Explain the meaning of market volatility in financial markets.
(3 marks)

d) Explain the difference between a bull and bear market.
(2 marks)

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  • 25 Marks

FM – MAY 2017 – L2 – Q2 – Foreign exchange risk and currency risk management | Introduction to Investment Appraisal

Discuss the advantages and disadvantages of the payback method, calculate the NPV for DÉCOR Ltd's investment, and analyze currency risk in an international transaction.

a) Payback method refers to the period of time it takes for the cash flows to cover the initial cost of investment or recoup the initial cost of investment. The period is usually calculated in years.

Required:
Identify TWO advantages and TWO disadvantages of using the payback method in investment appraisal.
(4 marks)

b) DÉCOR Ltd is analyzing the purchase of a new machine to produce product Z. The machine is expected to cost GH¢2,000,000. Production and sales of product Z are forecast as follows:

Year 1 2 3 4
Production & Sales (units/year) 70,000 106,000 150,000 72,000

The current selling price is GH¢30 per unit and is expected to increase by 5% a year. The current variable cost is GH¢18 per unit and is expected to increase by 6% per year. Fixed costs will remain the same, but an increase in working capital is required. Analysis of historical data of the levels of working capital of product Z indicates that, at the start of each year, investment in working capital will need to be 10% of sales revenue of that year.

The company pays tax at 25% per year in the year in which taxable profit occurs. The tax liability is reduced by the capital allowance on the machinery, and DÉCOR Ltd can claim on a straight-line basis over the four-year life of the proposed investment (capital allowance rate of 25% per annum). The new machine will have zero scrap value at the end of the four years. The cost of capital is 15% per year.

Required:
Calculate the Net Present Value (NPV) of the proposed investment and advise whether the proposed investment should be undertaken.
(11 marks)

c) An American company sells goods to a Ghanaian buyer for US$280,000 when the exchange rate is $1 = GH¢4.20. The Ghanaian buyer is allowed three months’ credit, and when the American company eventually receives the US dollars three months later and exchanges them for dollars, the exchange rate has moved to $1 = GH¢4.60.

Required:
i) What was the foreign exchange loss to the Ghanaian buyer?
(3 marks)

ii) Explain currency risk in relation to the above.
(2 marks)

iii) Explain transaction risk in relation to the above.
(2 marks)

iv) What will be the effect of the above on the company’s trading profits?
(3 marks)

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  • 5 Marks

FM – April 2022 – L2 – Q4a – Introduction to Investment Appraisal

Explain the limitations of using the Payback period method in investment appraisals.

In investment appraisal, many methods are available for use by finance and project professionals. One of these methods is the Payback period, but stakeholders have often raised questions on the usefulness of this method due to a number of limitations inherent in the use of the method.

Required:
Explain FOUR (4) limitations of using the Payback period method in investment appraisals. (5 marks)

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  • 20 Marks

FM – MAR 2024 – L2 – Q4 – Introduction to investment appraisal

This question involves calculating the NPV of a project, advising on whether to undertake the project, and explaining why NPV is preferred over the payback period as an investment appraisal method.

a) Toolo Ghana Ltd was recently formed as a special purpose vehicle (SPV) to provide a secondary market for investors involved in the domestic debt exchange programme who want to sell off their holdings for immediate cash.

The SPV was embarking on this special initiative as a one-off project; The company in year zero will acquire a total of GH¢500 million worth of bonds from investors and pay for all at the same time for cash.

Based on the projections, the expected cash inflows from the bonds are as follows:

  • Year 1 = GH¢100 million
  • Year 2 = Year 1 cash flows + 20% increase
  • Year 3 = Year 2 cash flows + 15% increase
  • Year 4 = Year 3 cash flows + 25% increase
  • Year 5 = Year 4 cash flows + 20% increase

A special investment in systems and software, computers and other fixed assets is GH¢6 million in year zero and tax deductible depreciation is on a straight-line basis with a scrap value of GH¢1 million. Salaries and wages and other administrative expenses will be GH¢1 million in year 1 and grow at 15% per annum on the previous year’s figure. Rent is also determined at GH¢0.5 million in year 1 and growing by GH¢100,000 each year.

The internal cost of capital is 22% whilst corporate tax rate is 25%.

Required:

i) Calculate the Net Present Value (NPV) of this project and advise whether Toolo Ltd should embark on the project.
(12 marks)

ii) Explain TWO (2) reasons why NPV is preferred to payback period.
(3 marks)

b) Soso Ghana Ltd is considering investing in project Sankofa which has been appraised to have an expected return of 25% per annum. The project’s beta is 1.9 and the risk-free interest rate is 14% per annum, which is 9% below the average return on equity stocks on the market.

Required:

Calculate the required return on project Sankofa and advise Soso Ghana Ltd whether it should invest in the project.
(5 marks)

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  • 15 Marks

FM – MAY 2019 – L2 – Q3a – Introduction to Investment Appraisal

Calculate and compare various investment appraisal metrics (ARR, NPV, IRR, Payback Period) for two mutually exclusive projects.

ASANTA Ghana Ltd is considering investing in the following projects which are considered mutually exclusive:

PROJECT GO PROJECT COME
Annual cash inflows GH¢1,000,000 GH¢2,000,000
Cost of Machine GH¢2,500,000 GH¢6,000,000
Scrap value of Machine GH¢250,000 GH¢1,000,000
Expected life of the Project 5 years 5 years

ASANTA Ghana Ltd uses the straight line method of depreciation. However, tax-allowable depreciation is 30% on a straight-line basis. The cost of capital for the company is 20% per annum.

Required:

  1. Calculate the Accounting Rate of Return (ARR) for each project. (4 marks)
  2. Calculate the Net Present Value (NPV) for each project. (4 marks)
  3. Compute the Internal Rate of Return (IRR) for each project. (4 marks)
  4. Compute the Payback period for each project. (3 marks)

(Note: In each of the above, advise the Company on which of the projects to implement or undertake.)

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