AMIS 212: Introductory Managerial Accounting Chapter 14, Module 5 AMIS 212 – Professor Marc Smith Chapter 14, Module 5 Chapter 14, Module 5 Slide 1 AMIS 212Introductory Managerial AccountingProfessor Marc SmithCHAPTER 1 MODULE 1Chapter 14 Module 5 Hi everyone welcome back! In the previous module we learned about the payback period. I’d like to start this one by going a little bit more into a discussion about payback. Now if you’d go to the next slide with me let’s get started.AMIS 212: Introductory Managerial Accounting Chapter 14, Module 5 AMIS 212 – Professor Marc Smith Chapter 14, Module 5 Slide 2 1 2 3 4 5$1,000 $0 $2,000 $1,000 $500When the cash flows associated with an investment project change from year to year, the payback formula introduced earlier cannot be used. Instead, the un-recovered investment must be tracked year by year.Chapter 14 Module 5: Payback Period When the cash flows that are associated with a particular project change from year to year meaning they are not the same, they are uneven, that equation that we learned to calculate the payback period won’t work. You can no longer use that. That formula that we saw in the previous module to come up with payback will only work if the cash flows are the same from year to year to year. Whenever you have a problem or a project where there are uneven cash flows, they differ from one year to the next; you must do a basic counting to come up with what would the payback period be? I did just sort of an illustration here; you’re just going to count. You’re going to count how many years it takes to generate these inflows to recover the initial cost of the project because that’s what the payback period is all about.AMIS 212: Introductory Managerial Accounting Chapter 14, Module 5 AMIS 212 – Professor Marc Smith Chapter 14, Module 5 That formula won’t work so what we do is simply count the years until we’ve got to the point where we have generated enough inflows to cover the cost. Go to the next slide with me. Slide 3 Cost to be recovered = $20,000Year 1 recover $9,000 ($11,000 still to recover)Year 2 recover $1,000 ($10,000 still to recover)Year 3 recover $7,000 ($3,000 still to recover)½ of Year 4 recover $3,000 (payback reached)Payback Period = 3 ½ yearsChapter 14 Module 5: Example #3The repair cost at the end of year 4 is not included in the payback calculation because it occurs after payback has been reached. Would you please take a look at example #3 from the website problems with me? Let’s just read it together. MT Glass is considering the purchase of a new machine that would cost $20,000 and is expected to reduce the operating costs for the next 5 years as follows. So you can see the cost savings in each of the 5 years that would be generated from the machine. It is estimated that this machine will need a repair at the end of the second year and at the end of the fourth year and each repair should cost $5,000.AMIS 212: Introductory Managerial Accounting Chapter 14, Module 5 AMIS 212 – Professor Marc Smith Chapter 14, Module 5 Calculate the payback period of the machine. We can’t use that equation here because the inflows are not the same every year, they’re uneven. So what we do is we simply count, and we count how many years it’s going to take to recover that $20,000 cost? How many years is it going to take to generate inflows from this machine totaling $20,000? So we know the cost of the machine is $20,000 and in year 1 it says that we will generate a $9,000 cost savings. So we have a $9,000 inflow, we haven’t hit payback yet we still have $11,000 left to recover. So go to year 2, in year 2 we’ll recover $1,000. Now there’s a $6,000 cost savings but it says at the end of year 2 we’ll have a $5,000 repair. So for the total for year 2 we’ll only have a $1,000 inflow leaving us with $10,000 still to recover. Go into the next year, count. So in year 3 we’ll have a $7,000 cost savings. Well we’re still not at payback right? We still have to generate an additional $3,000 of inflows to recover the cost. Now look at year 4. In year 4 you’re going to have a $6,000 cost savings but you only need to generate $3,000 to reach the payback period.AMIS 212: Introductory Managerial Accounting Chapter 14, Module 5 AMIS 212 – Professor Marc Smith Chapter 14, Module 5 Well it’s going to be $6,000 for the entire year, half of that would be the $3,000 cost savings. So halfway through year 4 we reach the payback period. Telling us the payback period for this machine is 3 ½ years. After 3 ½ years we will have generated enough inflows to recover the $20,000 cost of the machine. And you say that wasn’t so bad except wait a minute, the problem does say at the end of year 4 we’re going to have another repair of $5,000. So the question is why did I not incorporate that just like we did in year 2. In year 2 we did incorporate the $5,000 repair. Why did that not get incorporated into year 4? Well this is one of those problems with payback right? The repair cost at the end of year 4 is not included here. Because we reached the payback period before that repair cost happens. The payback period is reached after 3 ½ years. So everything happening after 3 ½ years is not going to affect the payback at all. That was one of the issues that we learned about previously in regards to the payback period. Now if you would please go to the next slide with me.AMIS 212: Introductory Managerial Accounting Chapter 14, Module 5 AMIS 212 – Professor Marc Smith Chapter 14, Module 5 Slide 4 • Does not focus on cash flows -- rather it focuses on accounting net income.• The following formula is used to calculate the accounting rate of return:Annual net income