The Payback period (PP)

The most often cited advantage of the payback period is its simplicity (Noreen, Brewer and Garrison, 2011). By definition, the payback period is simply the period its takes for the cash flows of a project to recoup the initial investment. This concept is fairly straight forward for most people to grasp. A manager need not have any advanced knowledge of finance to appreciate the fact that projects that can recover their initial investments as soon as possible should be preferred to their counterparts that take much longer to generate enough cash flows to cover the initial investments.

As applied to the present case, this advantage can be seen in the fact that HMT will simply need to know which of the two projects under consideration will be able to recoup their initial investment as first as possible. The case has not indicated the number of years within which HMT expects all its projects to at least be able to recoup their investment costs. With two mutually exclusive projects such as the one currently under consideration, the decision criterion is often to accept the project with the shortest NPV.  The ultimate decision on whether to accept or reject a project is, of course, subject to more than just the quantitative factors.

Although the technique does not rely on discounted cash flows, it has the advantage of implicitly incorporating the concept of time value of money (Noreen, Brewer and Garrison, 2011). By stipulating that projects with shorter payback periods should be preferred to their counterparts with longer periods, one can see that the payback period indeed incorporate the notion that money received today is worth more than money received further into the future.

Lastly, the payback period provides some rough basis of gauging the profitability of an investment (Noreen, Brewer and Garrison, 2011). This is particularly so in situations where there are other cash inflows beyond the payback period. The payback period can be seen as the point where the project breaks even in terms of covering the initial investment. Subsequent cash flows are, therefore, used to generate profits for the company.

Despite its advantages, the payback period is also fraught with a number of disadvantages. The first of these is that the method fails to take the time value of money into account (Noreen, Brewer and Garrison, 2011). The yearly net cash flows are often treated as if the purchasing power of the currency is constant throughout the period. The truth of the matter, however, is that cash flows occurring at different time periods are never the same even if they are equivalent in their absolute values. It is evident for this reason that the net cash flows for Year 1-Year 10 could   actually be the same in absolute value terms but have totally different purchasing powers at the given time when those cash flows are actually realized. The actual value to attach to those cash flows should always incorporate the time value of money even if they have the same absolute values throughout the period. Anything may happen in between to make it less likely that HMT will actually receive any of the yearly cash flows spread within the time horizon of the two projects. The risk reduces as the cash flows are nearer to the initial period.

In addition, the payback period has been criticised for ignoring cash flows occurring beyond the payback period (Noreen, Brewer and Garrison, 2011). Although this criticism is present in academic textbooks, this report does not consider it to be a disadvantage especially in view of the discussion of the advantages above. The method only sets some cut-off point but those calculating the payback period must first of all have all the necessary cash flows.

To compute the PP, one counts the number of years it takes for the cumulative cash flows to be equal to zero.

The Discounted Payback Period

Another possible appraisal technique that may be useful in assessing the relative acceptability of either of the two projects is the discounted payback period (DPP). As a technique, it embraces all the advantages of the payback period in addition to taking account of the aspect of time value of money. One can, therefore, see this approach as an improvement over the payback period.

Net present value (NPV)

The NPV approach expresses the net cash flows of a project in their current monetary terms (Arshad, 2012). This means that the cash flows that occur into the future are discounted using a chosen discount rate to get their value in present terms. The decision criteria under the NPV approach is to accept only mutually exclusive projects with the highest positive NPVs that are greater than $0(Arshad, 2012). It follows from this that HMT will have to consider which of the two projects satisfy the decision criterion under the approach in addition to any other conditions specific to the firm.

Unlike the other approaches that do not take account of the time value of money, the NPV is an objective basis for evaluating projects on their ability to maximize shareholder wealth (Atrill & McLaney, 2009). Knowing that the NPV for either of the projects is objectively indicates that shareholders of HMT will be better off by the same amount. In addition, this approach fully accounts for the time value of money. This can be seen in the fact that NPV analysis must utilize selected discount rates to discount the various yearly cash flows.

Despite its many advantages, the NPV has two major disadvantages. For one, the approach fails to provide a means of gauging the profitability of a project (Atrill & McLaney, 2009).Analysis based on the approach would not enable HMT to know how profitable either of the two proposed projects are simply by looking at the calculated NPV. After all, a project of a different initial cash outlay may also end up with the same NPV.Furthermore; many people find it difficult to understand NPV in contrast to the perception of payback period. The consequence of this is that managers without a proper grounding in finance may completely fail to appreciate the approach.

The Internal Rate of Return (IRR)

The acceptable definition of IRR is that it is the discount rate that gives and NPV of zero (Atrill & McLaney, 2009). The decision rule under this appraisal is to accept the mutually exclusive project with the highest IRR.  It also have advantages and disadvantages just like the other approaches already discussed.

Like all the discounted approaches, the IRR accounts for the time value of money in investment evaluation. This is important given the fact that capital budgeting projects are normally spread far apart from each other. Accounting for this spread makes the technique more appropriate than the arbitrary processes such as the PP.

The technique is also good as it accounts for all the cash flows of the project unlike the PP which ignores all cash flows occurring after the set cut-off period. This means that the accept reject decision under the IRR is of better quality than under the PP.

Problems with the IRR arise from the fact that it can sometimes produce more IRRs or even fail to produce one at all. This makes the results of IRR computations meaningless at certain times. The other shortcoming stems from the assumption in IRR computation that the firm can always reinvested the project cash flows at a constant rate. It is an assumption that flies in the face of reality on the ground since some of the cash flows attributed to a project are often not reinvested back.

 

Relevant Cash Flows

An important consideration in evaluating the two projects is a clear understanding of the cash flows that are relevant as against the ones that are not relevant. A cash flow is said to be relevant if the decision to adopt the given project leads to a change in that particular cash flow component.

Relevant Cash Flows for GPS Transmitter

Initial cash flows

For the GPS project, the initial cash flows would be comprised of the cost of purchasing the patent, the net cost of buying the software after considering the tax benefits as well as the additional net working capital that is needed to start off the project. Appendix 2 in the attached excel worksheet shows that the initial cash flows comes to a net amount of ($2,400,000) indicating that it is a net cash outflow. The ($ 700,000) relating to the software purchase comes about because the company would be able to claim 30% of the $1,000,000 cost of purchasing the software as a loss in the current financial year. This means that the company will only spend $700,000 after factoring the tax benefit.

Operating cash flows

Operating cash flows are simply incremental after tax cash in-flows that are associated with a given project. The computation of operating cash flows follows the income statement approach whereby the final after tax profit is adjusted for non cash items such as capital cost allowance on patents. The computed figures for operating cash flows can be seen in the Appendix 2 in the attached excel worksheet where there is a row named Net Operating Cash flows. A summary of those figures are shown in the table below.

Year	1	2	3	4	5	6	7	8	9	10
($)	(97500)	(45000)	12750	76275	33653	33653	33653	33653	33653	33653

 

Terminal Cash Flows

These are the cash flows arising at the end of the project excluding the operating cash flows. In the case of the GPS project, the terminal cash flows are simply the recaptured Net Working Capital that had been invested at the beginning of the project. The terminal cash flows is $200,000 as shown in Appendix 2 of the attached excel worksheet.

Summary of the relevant cash flows for the GPS Transmitter

A summary of all the relevant cash flows for the GPS transmitter is shown in the table below. The initial cash flows is the cash flows for year 0 when the project is initiated.

Year	0	1	2	3	4	5-9	10
NCF	(2400000)	(97500)	(45000)	12750	76275	33653	233653

 

Relevant Cash Flows for Surveillance Aircraft

Initial cash flows

For the GPS project, the initial cash flows would be comprised of the cost of purchasing the patent, the net cost of buying the software after considering the tax benefits as well as the additional net working capital that is needed to start off the project. Appendix 3 in the attached excel worksheet shows that the initial cash flows comes to a net amount of ($2,850,000) indicating that it is a net cash outflow.

Operating cash flows

Operating cash flows are simply incremental after tax cash in-flows that are associated with a given project. The computation of operating cash flows follows the income statement approach whereby the final after tax profit is adjusted for non cash items such as capital cost allowance on patents. The computed figures for operating cash flows can be seen in the Appendix 3 in the attached excel worksheet where there is a row named Net Operating Cash flows. A summary of those figures are shown in the table below.

Year	1	2	3-5	6-10
Cash Flows($)	(1,126,000)	(76,000)	2,024,000	1,934,000

 

Terminal Cash Flows

These are the cash flows arising at the end of the project excluding the operating cash flows. In the case of the Surveillance Aircraft project, the terminal cash flows come to a total of $1,220,000 as shown in  Appendix 3 of the attached excel worksheet.

Summary of the relevant cash flows for the Surveillance Aircraft Project

A summary of all the relevant cash flows for the GPS transmitter is shown in the table below. The initial cash flows is the cash flows for year 0 when the project is initiated.

Year	0	1	2	3-5	6-9	10
NTC	(2850000)	(1126000)	(76,000)	2,024,000	1,934,000	3,154,000

 

Computing the respective costs of capital

It is important in the analysis to first come up with the cost of capital given the information. The relevant cost of capital is the weighted average cost of capital (WACC) given the fact that HMT is financed by both debt and equity.

Cost of equity

It is already stated that HMT raises most of its equity capital through retained earnings. This means that the relevant cost of equity for the present purposes will exclude the issuance costs that are only applicable if the company was issuing new equity capital. The computation will assume that the firms presented in Exhibit 1 are pure play firms such that the average of their betas is the HMT beta. This is then used to calculate the cost of common equity using the Capital Asset Pricing Model (CAPM).

Under the CAPM, the formula for calculating the cost of equity is presented below:

Where:

The cost of common stock equity is 12.33%.See Appendix 1 in the attached excel worksheet for the computations.

Cost of debt

The present analysis will further assume that Sky Hawk Limited is a pure play firm for the purposes of computing the cost of debt. The before tax cost of debt will be the same as the yield to maturity on recently issued Sky Hawk Limited’s 10 year bond. The after tax cost of debt is 5.09% as calculated from Appendix 1 in the attached excel worksheet.

The Weighted Average Cost of Capital (WACC)

This is the cost of capital given the various financing sources for the given organization. In the case of HMT, finances are derived from both debt and equity in the various weights given. The WACC for the firm is 9.43% calculated as detailed in Appendix 1 in the attached excel worksheet.

The Evaluation

With the relevant cash flows already identified coupled with the fact that the firm’s WACC has also been established, the next stage in the report would be to subject those cash flows to the analysis under the three decision tools of NPV,IRR and Discounted Payback Period as instructed. Appendix 4 in the attached excel worksheet will be used for most of the calculations.

 

References

Ardalan,K., 2012.Payback Period and NPV: Their Different Cash Flows. Journal of Economics   and Finance Education, 11(2), 10-16.

Atrill,P. And McLaney, E., 2009.Managment Accounting for Decision Makers.6^th ed.Harlow,       Essex: Pearson Education Limited.

 

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