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Principles of Finance Videos 166 videos

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


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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

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