Question

This will focus on analyzing and evaluating a time value of money capital budgeting scenario

Describe, and explain how the following computations pertain to the company’s profitability, and how the required rate of return (discount rate)and these computations impact the projector projects’ approval:

5. Break-Even Time (BET)

Answer 1

Break even time (BET) is the time period in which total investment of the firm is recovered from the cash flows and profit generated. The lower the break even time it is good for the firm since the initial investment will be recovered at the earliest. During volatile and uncertain times recovering the initial investment in the projects is very important for the firm. Cash is King and hence generating and preserving the cash is of utmost important to any firm. The break even time is calculated dividing total fixed cost by the contribution margin generated in the time period. The break even time can be calculated based on cash and non cash basis. Cash basis of calculation is preferred since cash generation is an important key performance indicator for the firm.

The discount rate is the cost of capital of the firm used in evaluation of cash flows to its present value. The higher the discounting rate riskier is the project since the future cash flows will be reduced in terms of present value. A project having positive net present value (present value of cash inflows – Initial investment) should be accepted since it will add value to the firm. A project having negative net present value should be rejected.