Question

Is the overhaul costs suppose to be accounted for when calculating the payback period???

	Alternative A	Alternative B	Alternative C
Cost	$1,000,000	$1,250,000	$2,000,000
Setup Costs	$0	$50,000	$50,000
Training costs	$10,000	$25,000	$35,000
Annual maintence costs	$10,000	$15,000	$16,000
Anticipated annual savings	$125,000	$190,000	$225,000
Annual labor savings	$25,000	$0	$40,000
Expected useful life in years	8	9	7
Overhaul costs in year 4	$45,000	$50,000	$35,000

Step-1: Calculation of payback period:

Particulars	Alternative-A (in $)	Alternative-B (in $)	Alternative-C (in $)
Initial Investment
Cost	10,00,000	12,50,000	20,00,000
Setup Cost	0	50,000	50,000
Training cost	10,000	25,000	35,000
Total Initial Investment	10,10,000	13,25,000	20,85,000
Net Annual Cash Inflows
Annual savings	1,25,000	1,90,000	2,25,000
Annual Labor Savingd	25,000	0	40,000
Total savings (A)	1,50,000	1,90,000	2,65,000
Annual maintenance cost (B)	10,000	15,000	16,000
Net Annual Cash Inflows (A)-(B)	1,40,000	1,75,000	2,49,000
Payback Period =Net investment/Annual Cash flow	7.21	7.57	8.37
Ranking	1	2	3

Step-2: Calculation of Net Present value

Particulars	Alternative-A (in $)	Alternative-B (in $)	Alternative-C (in $)
Initial Cash Outflow (Step-1)	10,10,000	13,25,000	20,85,000
Overahall expesnes in 4th year	45,000	50,000	35,000
PVF @ 12%	0.636	0.636	0.636
PV of ovehall expenses	28,620	31,800	22,260
PV of total cash outflows	10,38,620	13,56,000	21,07,260
PV of Net cash Inflows
Net Annual Cash Inflows (Step-1) (A)	1,40,000	1,75,000	2,49,000
No of Years	8	8	7
PVAF @12% (B)	4.967	4.967	4.564
PV of cash in flows (A)*(B)	6,95,380	8,69,225	11,36,436
Net Present value=PV of cash inflows-PV of cash outflows	(3,43,240)	(4,86,775)	(9,70,824)
Ranking	1	2	3

Step-3: Calculation of Accounting rate of return:

Particulars	Alternative-A (in $)	Alternative-B (in $)	Alternative-C (in $)
Average Annual Profit:
Annual Cash Inflows	1,40,000	1,75,000	2,49,000
No of Years	8	9	7
Total Inflow over period	11,20,000	15,75,000	17,43,000
Less: Overhaul cost	45,000	50,000	35,000
Less: Depreciation (No salvage value)	10,10,000	13,25,000	20,85,000
Total Profit/(loss) of project	65,000	2,00,000	(3,77,000)
Useful life	8	9	7
Average Annual Profit	8125	22,222	Nil
Average Investment
Initial Investment	10,10,000	13,25,000	20,85,000
At the end salvage value	0	0	0
Average Investment=(initial investment+ At the end salvage value)/2	5,05,000	6,62,500	10,42,500
Accounting rate of return=Average Annual Profit/Average investment	1.6%	3.35%	O%
Ranking	2	1	3

Step-4: Internal Rate of Return:

Particulars	Alternative-A (in $)	Alternative-B (in $)	Alternative-C (in $)
NPV @ 10%
Initial Outflows	10,10,000	13,25,000	20,85,000
Overhall expense at the end of 4th year	45,000	50,000	35,000
PVF @10%	.683	0.683	0.683
PV of Overhall expense	30,735	34,150	23,905
Total Initial outflows	10,40,735	13,59,150	21,08,905
Net annual cash flows	1,40,000	1,75,000	2,49,000
Annuity factor@10%	5.3349	5.7590	4.8684
Annuity cashflows	7,46,886	1007825	12,12231
NPV @10%	(293849)	(351325)	(8,96,674)
NPV @12%	(3,43,240)	(4,86,775)	(9,70,824)
IRR=10%+NPV1*(R2-R1)/(NPV1-NPV2)	10.93%	10.83%	10.96%
Ranking	2	3	1

Step-5: Analysis Table (Ranking Table)

Particular	Alternative-A	Alternative-B	Alternative-C
Payback Period	1	2	3
NPV	1	2	3
Accounting rate of return	2	1	3
Internal Rate of return	2	3	1

Answer 1

Yes, all relevant expenses are to be considered for computation of payback period.

Payback period represents the period within which the initial investment would be recovered. Since there are overhaul expenses in year 4, it implies that there is a cash outflow which does not allow the initial investment to be recovered.

For computing the payback period, the annual cash flows should be calculated which would be lesser in year 4 due to overhaul expenses. The cash flows are then cumulated to analyse the period in which the initial investment is completely recovered. Hence overhaul costs should be considered.