AMIS 212: Introductory Managerial Accounting Chapter 14, Module 4 AMIS 212 – Professor Marc Smith Chapter 14, Module 4 Chapter 14, Module 4 Slide 1 AMIS 310Foundations of AccountingProfessor Marc SmithCHAPTER 1 MODULE 1Chapter 14 Module 4 Hi everyone, welcome back. In this module let’s take a look at the other two capital budgeting techniques, the payback period and the accounting rate of return. Let’s get started, go ahead to the next slide with me.AMIS 212: Introductory Managerial Accounting Chapter 14, Module 4 AMIS 212 – Professor Marc Smith Chapter 14, Module 4 Slide 2 The payback period is the length of time that it takes for a project to generate enough cash inflows to recover the initial cost of the project.Said another way, the payback periodrepresents the length of time it will take for a project to pay for itself.The shorter the payback period the better.Chapter 14 Module 4: Payback Period The payback period, we’ll start with that one. The payback period represents the length of time that it will take for a project to generate enough cash inflows to recover the initial cost of the project. Thinking about it a different way or saying it a different way, the payback period represents the length of time it will take for a project to pay for itself. How long will it take for a project to generate enough inflows to basically pay for what we had to spend to buy the equipment or whatever? Please note as far as payback goes the shorter the payback period the better. The shorter the payback period the quicker we recover the cost of the project. Now go to the next slide with me.AMIS 212: Introductory Managerial Accounting Chapter 14, Module 4 AMIS 212 – Professor Marc Smith Chapter 14, Module 4 Slide 3 To calculate the payback period:Payback period = Initial investmentNet annual cash inflowChapter 14 Module 4: Payback PeriodNote that this is the same formula used to calculate the IRR factor To calculate your payback period, come up with the payback period, it is equal to the initial investment divided by the annual net cash inflows. And for a quick and discerning eye you will note that the equation to calculate payback is the exact same formula that we use to come up with the IRR factor we saw in the previous module. So you kind of get a two for one. You get the IRR factor and you get the payback period using the exact same equation. Now go to the next slide with me.AMIS 212: Introductory Managerial Accounting Chapter 14, Module 4 AMIS 212 – Professor Marc Smith Chapter 14, Module 4 Slide 4 Management at The Daily Grind wants to install an espresso bar in its restaurant.The espresso bar:1. Costs $140,000 and has a 10-year life.2. Will generate net annual cash inflows of $35,000.Management requires a payback period of 5 years or less on all investments.What is the payback period for the espresso bar?Chapter 14 Module 4: Payback Period And here’s just another little example. And here’s what it says, management at The Daily Grind wants to install an espresso bar in its restaurant. And the espresso bar will 1-cost $140,000 and should last for about 10 years. And 2-the reason they’re considering doing this; it will generate annual net cash inflows of $35,000. It will generate profits of $35,000 per year. Management requires a payback period of 5 years or less on all investment projects. So here’s what I want you to do, given that calculate the payback period for the espresso bar and let’s determine if the management at The Daily Grind should in fact install the bar or not. Let’s do it, go to the next slide with me.AMIS 212: Introductory Managerial Accounting Chapter 14, Module 4 AMIS 212 – Professor Marc Smith Chapter 14, Module 4 Slide 5 Payback period = $140,000 $35,000Payback period = 4.0 yearsAccording to the company’s criterion, management would invest in the espresso bar because its payback period is less than 5 years.Chapter 14 Module 4: Payback PeriodPayback period = Initial investmentNet annual cash inflow There’s our equation. Payback is equal to the initial investment divided by our annual net cash inflows. Well that was given to us. The initial investment, the cost of installing the bar is $140,000. The reason we would do it is it would generate annual net cash inflows of $35,000. So your payback period on the espresso bar would represent or would be 4 years. And please note according to the criteria established by the company we should in fact install the espresso bar. The payback period of 4 years is less than the threshold of 5 years.AMIS 212: Introductory Managerial Accounting Chapter 14, Module 4 AMIS 212 – Professor Marc Smith Chapter 14, Module 4 So according to that the espresso bar should be installed, it generates a lower payback than what we have said. Go ahead to the next slide with me. Slide 6 Chapter 14 Module 4: Payback PeriodAdvantage of Payback Method:1. It is very easy to use, calculate, andunderstandDisadvantages of Payback Method:1. It ignores the time value of money2. It ignores all information that occurs afterthe payback period has been reached I want to talk a little bit about payback. Payback is commonly used. Lots of companies use payback in different forms. And there are goods and bads to payback. The good, the big advantage, the big positive to payback period, it’s just easy. It’s easy to use, it’s easy to calculate, and it’s simply easy to understand. Everybody in the organization, even those that might be quantitatively challenged let’s say, can understand what a payback period is telling them.AMIS 212: Introductory Managerial Accounting Chapter