Acc 305 Deferred Compensation And Assessment Answer

The payback period is the amount of time it takes for a project to recover an investment. How is the payback period computed and what are its advantages and disadvantages.Assume that you have been offered an executive position with a major corporation. The company gives you two compensation options: deferred compensation or advance payment. How would you decide which option to select.

Answer:

With regards to the given choice between deferred compensation and advance payment, there are two main factors which need to be considered. One of these is the underlying tax implication as deferred compensation is usually practiced when the employee wants to lower the tax outflow and thereby intentionally delays the receipt of salary by opting for deferred compensation. Thus, based on the marginal tax rate that is currently applicable for the employee, a decision may be taken as to whether there is merit with regards to delaying the compensation (Damodaran, 2014).

Another crucial factor to be considered is the time value of money. As money has opportunity cost, hence it is better to receive the payments at an early date rather than in a deferred manner. This essentially is based on the underlying premise that proceeds received in the present can be used to earn interest or returns which form the opportunity cost in case of deferred compensation (Parrino & Kidwell, 2014).. As a result, the magnitude of the cash flows that would be receivable net of tax in both the cases must be obtained. The deferred compensation ought to be then discounted at a suitable discount rate so as to match the time period of advance payment so that the optimum choice may be exhibited.

The payback period is computed by considering the cumulative incremental cash flows from the given project. Based on the year when the cumulative cash flow turn out to be positive, considering uniform cash flow during the year, the payback period is computed. It is imperative to note that payback period does not consider the discounted cash flows and is based on undiscounted cashflows arising from the project (Damodaran, 2015).

One of the key advantages of payback period is that it is simple to compute. Also, it is not impacted by the discount rate which often may be difficult to decide with high degree of precision. Besides, this technique is easy to understand even for people who do not have financial background (Brealey, Myers & Allen, 2014). However, one of the key disadvantages associated with this method is that it does not consider the time value of money and hence is inferior to other techniques such as NPV and IRR. Besides, it considers the cash flows only till the time initial investment is recovered. The cash flows after this period are ignored and hence this is often used to complement other more accurate techniques like NPV and IRR (Parrino & Kidwell, 2014).

References

Brealey, R. A., Myers, S. C. & Allen, F. (2014) Principles of corporate finance, 6th ed. New York: McGraw-Hill Publications

Damodaran, A. (2015). Applied corporate finance: A user’s manual 3rd ed. New York: Wiley, John & Sons.

Parrino, R. & Kidwell, D. (2014) Fundamentals of Corporate Finance, 3rd ed. London: Wiley Publications


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