ShmoopTube

Where Monty Python meets your 10th grade teacher.

Search Thousands of Shmoop Videos

Principles of Finance: Unit 7, Breakeven and Payback Time 4 Views


Share It!


Description:

Everything you’ve ever wanted to know about breaking even and payback time, served with a cup of refreshing absinthe lemonade.

Language:
English Language

Transcript

00:00

Principles of finance ah la shmoop break even and pay

00:05

back time it's pay back time would be shmoop sounds

00:09

like a schwarzenegger line but it's not it's Really not

00:14

like what a simple concept when you invest in a

00:16

project or stock or a whatever dot com you want

00:19

to know when and or how to get your money

00:21

back And then ideally a good bit more than that

00:24

amount of money afterwards to pay you back for the

00:26

risk you took in the time you had the dough

00:28

in the pot So popular exercise in accounting land is

00:31

to calculate the amount of time it takes on a

00:33

given investment to simply get paid back the initial capital

00:36

you laid out for say that cup stamper That cost

00:39

you though three million bucks all paid up front with

00:42

your cash Well that stamper saves you a nickel a

00:45

cup versus having toe by cops from cups are us

00:48

So you have two stamp three million cops divided by

00:52

point zero five or sixty million cups to break even

00:56

Sort of You sell a million cops of laminate a

00:58

month Steadily so easy calculation Right in sixty months the

01:02

three million boxes paid back and everything from there is

01:05

profit contribution right Wrong The machine doesn't just maintain or

01:09

insure itself So in reality it costs another penny A

01:13

cop toe Look after that stamp for a machine thing

01:15

Oil it and you know pay the robot to run

01:18

it and wipe it off When it's bill's what union

01:21

Robots they make bank So in reality it's not five

01:24

cents a cup You save in running that machine It's

01:26

really Four cents and it's not sixty million cups to

01:29

pay it back It's really Three million divided by four

01:33

cents a cut or seventy five million cups to pay

01:35

it back Oh and one other little thing Capital isn't

01:39

free Remember you took three million box out of your

01:42

two percent a year earning money market account to pay

01:45

for that stamping factory thing Well the three million bucks

01:48

earned you a very safe sixty grand a year That

01:52

money was vastly more rock solid safe than your entire

01:55

absence Lemonade stand business Yeah When you spent three million

01:59

bucks on the machine you made this huge risky bet

02:03

with your capital that the business would be around long

02:06

Enough to pay back the value of the machine and

02:08

then some shouldn't leave value of that capital at some

02:12

rate higher than the super safe Two percent bank returns

02:15

well if you had to go out into the market

02:17

and borrow money pledging that stamper as collateral on the

02:20

market would price it much higher More like on ten

02:23

fifteen twenty percent let's pick ten percent now because the

02:26

math is easy is ten percent a fair number to

02:28

use for the opportunity cost for your capital being spent

02:31

on the cup Stamper Well you're the one controlling the

02:34

process it's not a cold arm's length transaction done with

02:37

a vendor who doesn't actually know you and your fine

02:40

work ethic there since it's all your money and your

02:42

time and attention on this one process well your risk

02:45

should certainly be less than the and percent market price

02:48

sitting out there So for lack of a better process

02:51

and you split the difference and call the cost of

02:53

your capital the opportunity cost and risk adjusted Numbers 6

02:56

percent c had the two percent risk free money market

02:59

price thing going on then the ten percent mark pricing

03:01

there again it took the average ten plus two is

03:04

twelve in the ice bye bye to highly scientific And

03:06

normally you need a phd to do all this arithmetic

03:09

So anyway now on top of everything you have the

03:12

six percent a year to cover the risk of using

03:15

your own capital versus just buying cups Ala carte from

03:18

cups are us as you go along well that six

03:21

percent on three million box is one hundred eighty grand

03:24

a year to rent and that's an ongoing costs like

03:27

every year as the quote principal unquote is aid off

03:30

the extra hundred eighty grand in costs at four cents

03:34

a cop net savings Well then that's one hundred eighty

03:36

grand divided by point zero four or an additional four

03:40

and a half million cops a year at least in

03:42

your one So let's say you continue to sell a

03:45

million cups of absence lemonade a month with no wasted

03:48

your breakage or other forces like a union robot strike

03:52

You know that's the thing Well after one year we've

03:54

sold twelve million cups as part of your absence lemonade

03:57

sales and those twelve million cops have saved you now

04:00

For sensei so four cents times twelve million is total

04:04

savings this year of four hundred eighty grand and let's

04:07

say you pay off an annual chunks notionally the quote

04:10

debt you borrowed from yourself and that four hundred eighty

04:13

grand gets one hundred eighty grand taken out of it

04:15

to rent the three million dollars risk adjusted to have

04:18

bought that stamper Don't leave you three hundred grand to

04:21

pay down your loan to being now essentially two point

04:23

seven million Well you have less notional principal outstanding now

04:27

so less to pay down unless to pay off your

04:30

a reducing risk here And certainly the risk of the

04:32

machine is lower because you've used it a year and

04:35

it generally works and well you know it's good to

04:37

control your own stamping Those cups are an integral part

04:40

of your business and it's important to have them stamped

04:42

with pithy sayings like absence makes the brain grow foggier

04:47

The rest of this exercise revolves around how many cups

04:49

a year you sell saving you four cents each and

04:51

then how quickly you pay off your notional quote debt

04:54

unquote back to yourself regardless this capital expenditure when given

04:58

the full set of inspection numbers however is way more

05:00

complex and it initially appeared to be and way less

05:04

of a boon to our business Why Because we have

05:07

to account for the cost of our capital like we

05:09

could've put it elsewhere We could've bought marketing with him

05:11

He could have bought back our own stock and in

05:14

addition all of this there lies the specter out there

05:17

that absence lemonade sales could actually declined to say ano

05:21

eight hundred thousand five hundred thousand then maybe three hundred

05:24

thousand a month At that point buying your own stamper

05:27

was a total waste of your capital You should have

05:29

just paid up for the outside vendor at whatever since

05:32

it was per cup and not tried to save the

05:35

four cents But on the other hand if sales skyrocket

05:38

thanks to the kitschy sayings on your cups and you

05:41

grow to selling two million and three million cups a

05:44

month and maybe four five then in a year you

05:47

would have sold us a forty million cops and save

05:49

those four cents And yeah that would be a total

05:51

savings just in that year of one point six million

05:55

Bucks by virtue of having your own stamper and wow

05:58

then your machines value will have paid off handsomely You

06:01

got big numbers toe warrant spending your precious capital on

06:04

stuff like this The big notion here is that break

06:07

even analysis and payback have to consider exogenous or none

06:11

obvious things like the risk of the investment being a

06:14

total bust or the opportunity cost loss for what else

06:17

a company could have done with that capital including nothing

06:21

It's got also include the maintenance insurance and other costs

06:24

associated with a purchase The risk of you know robot

06:26

union strikes are rebelling on you including taxable things like

06:30

gains from depreciating that asset meaning you kind of got

06:33

paid in tax by having spent the capital then being

06:36

allowed to depreciate it against profits You didn't think about

06:39

that one did you So yeah there's the tax help

06:41

hereand appreciating that machine three hundred grand a year over

06:44

ten years to then be zero The tax savings would

06:47

have been worth some one hundred grand or so or

06:49

two point five million cups worth a year But okay

06:52

enough absent for one day we know you miss your 00:06:54.894 --> [endTime] drones

Up Next

GED Social Studies 1.1 Civics and Government
39794 Views

GED Social Studies 1.1 Civics and Government

Related Videos

Fake News
11938 Views

How do you tell fake news from real news?

Finance: What is Bankruptcy?
260 Views

What is bankruptcy? Deadbeats who can't pay their bills declare bankruptcy. Either they borrowed too much money, or the business fell apart. They t...

Finance: What is a Dividend?
1777 Views

What's a dividend? At will, the board of directors can pay a dividend on common stock. Usually, that payout is some percentage less than 100 of ear...

Finance: How Are Risks and Rewards Related?
589 Views

How are risk and reward related? Take more risk, expect more reward. A lottery ticket might be worth a billion dollars, but if the odds are one in...