Page 341 - F2 - MA Integrated Workbook STUDENT 2018-19

Capital budgeting

3.3 Uneven annual cash flows

If cash flows are uneven (a more likely state of affairs), the payback has to be
calculated by working out the cumulative cash flow over the life of a project.

Example 1

Company X has a policy of only accepting projects that give a pay back of
four years or less. A machine is available for purchase at a cost of $150,000.
We expect it to have a life of five years and to have a scrap value of $20,000
at the end of the five-year period.

We have estimated that it will generate net cash flows over its life as follows:

$000

1st year 40
2nd year 75

3rd year 60
4th year 30

5th year 10
Step 1 – set up a table with columns for year, cash flow, and cumulative
balance.

Step 2 – put in the figures and calculate the cumulative balance until we get a
positive figure (have paid back the investment).
Year Cash flow Cumulative cash flow
$000 $000
0 (150) (150)
1 40 (110)
2 75 (35)
3 60 25
4 30
5 30
Step 3 – work out what fraction of a year was required in the last year of
payback.

$35,000 ÷ $60,000 × 12 = 7 months or
$60,000 ÷ 12 = $5,000 a month, $35,000 ÷ $5,000 = 7 months
Payback period – 2 years and 7 months therefore accept

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