Why do we have to calculate the Payback period with the incremental profits and not only with the profits from the second store?

Question

Exhibit or Question Guidance:

Question 2 Profit Calculations Diagon Alley Original Profit:

Overhead: $108K/year
Insurance: $1,900/month * 12 = $22,800
Tax: $600/month * 12 = $7,200
Total Yearly Costs: $138,000
Total Yearly Profit = $240,000 - $138,000 = $102,000
New Stores Profit:
Overhead: $156K/year
Insurance: $2,800/month * 12 = $33,600
Tax: $1,200/month * 12 = $14,400
Total Yearly Costs: $204,000
Total Yearly Profit = $360,000 - $204,000 = $156,000 INCREMENTAL YEARLY PROFIT = $54,000
ROI Calculation:
Capex for new store = $200K
$200k/$54K = 3.7 years <- perfectly okay for candidate to round here as long as they realize they recoup the investment within 4 years of opening

Answer 1

Hello!

The reason you only need to use the incremental yearly profit is because the second calculation is for the two stores taken together, not just the second store:

Store 1 net profit = $102,000
Store 1 + Store 2 net profit = $156,000
Store 2 incremental yearly profit to the company = $54,000

Given you are already making $102,000 from the first store, adding the second store will make you an additional $54,000. Your investment of $200,000 results in this additional $54,000, so you use this number to calculate how long it takes to recoup your investment.

Best,

Maria

Answer 2

Hey!

We use incremental profit to calculate the payback period because we want to measure the additional return generated by the second store compared to the existing one. The goal is to see how long it takes for the new investment ($200K) to pay for itself. If we only looked at the second store’s total profit, we wouldn’t account for the fact that some of its costs would exist regardless. By focusing on the $54K incremental profit, we ensure an accurate ROI calculation. Hope that helps! ?

Alessa

Answer 3

Hey there,

Because we are investing $200k in a new store, we want to know how long that new venture takes to repay itself. So we look at its:

Incremental revenes ($360k), less
Incremental costs ($204k), giving us
Incremental profit ($56k)

Thereby $200k/$54K = 3.7 years

All the best