University:
Grand Rapids Community College
Course:
Financial and Managerial Accounting: Information for Decisions - John J. Wild
Academic year:

2024
Views:

161

Pages:

2
Author:

stud_ice13

Break-Even Time (BET) Analysis The Break-Even Time (BET) method evaluates the time required for an investment’s discounted cash flows to equal the initial investment cost. Unlike the traditional payback period, BET incorporates the time value of money by discounting future cash flows, making it more accurate for assessing investment recovery. Calculating Break-Even Time 1. Discount Future Cash Flows: Each year’s net cash flow is discounted using the company’s required rate of return. 2. Cumulative Discounted Cash Flow: Track the cumulative sum of these discounted cash flows until it matches or exceeds the initial investment. 3. Determine the Break-Even Point: BET is the exact point in years when cumulative discounted cash flows equal the initial investment. If the cumulative discounted cash flow turns positive during a specific year, BET can be calculated by dividing the remaining amount required by that year’s discounted cash flow and adding it to the number of full years passed. Example Calculation For a $12,000 machinery investment with $4,100 in annual net cash flows for five years, discounted at 10%: • • Yearly Discounted Cash Flows: Apply the 10% discount rate to each year’s cash flow, then calculate cumulative totals. Finding BET: In Exhibit 24.14, the cumulative discounted cash flow turns positive between years 3 and 4, specifically at 3.64 years. This is calculated by dividing the remaining amount required after Year 3 ($1,805) by the Year 4 discounted cash flow ($2,800), yielding approximately 0.64 years, which is added to the 3 years. The 3.64-year BET signifies that after this point, cash flows will start generating a positive net present value. Use of Break-Even Time in Decision-Making BET helps managers determine when an investment starts to yield positive returns, considering the time value of money. Investments with shorter BETs are ranked higher, as they provide returns faster, enhancing liquidity and reducing risk exposure. Comprehensive Example: Project Evaluation Using BET, NPV, and IRR West Company is analyzing two potential projects, T1 and T2, each requiring an initial investment of $101,250, with varying cash flow patterns. 1. Payback Period Calculation: o Project T1: Unequal cash flows yield a payback period of 2.73 years (recovery occurs partway through Year 3). o Project T2: Equal cash flows lead to a shorter payback period of 2.53 years. 2. NPV Calculation: o With a required 10% return, both projects yield negative NPVs, indicating that neither meets the company’s profitability threshold. 3. IRR Calculation for Project T2: o Present Value Factor Calculation: Dividing the initial investment by the annual cash flow provides a factor of 2.5313. This corresponds to an IRR of 9% (from a present value table). o Decision: Since Project T2’s IRR is below the 10% hurdle rate, it fails to meet the company’s return requirement. Summary BET, along with NPV, IRR, and Payback Period, offers a comprehensive approach to evaluating investment recovery, considering both the timing and time value of returns. When comparing options, BET is particularly valuable for prioritizing investments that generate positive returns sooner, supporting liquidity and reducing investment risk.