In: Accounting
Average Rate of Return, Cash Payback Period, Net Present Value Method for a Service Company
Spanish Peaks Railroad Inc. is considering acquiring equipment at a cost of $165,000. The equipment has an estimated life of 10 years and no residual value. It is expected to provide yearly net cash flows of $33,000. The company's minimum desired rate of return for net present value analysis is 15%.
Present Value of an Annuity of $1 at Compound Interest | |||||
Year | 6% | 10% | 12% | 15% | 20% |
1 | 0.943 | 0.909 | 0.893 | 0.870 | 0.833 |
2 | 1.833 | 1.736 | 1.690 | 1.626 | 1.528 |
3 | 2.673 | 2.487 | 2.402 | 2.283 | 2.106 |
4 | 3.465 | 3.170 | 3.037 | 2.855 | 2.589 |
5 | 4.212 | 3.791 | 3.605 | 3.353 | 2.991 |
6 | 4.917 | 4.355 | 4.111 | 3.785 | 3.326 |
7 | 5.582 | 4.868 | 4.564 | 4.160 | 3.605 |
8 | 6.210 | 5.335 | 4.968 | 4.487 | 3.837 |
9 | 6.802 | 5.759 | 5.328 | 4.772 | 4.031 |
10 | 7.360 | 6.145 | 5.650 | 5.019 | 4.192 |
Compute the following:
a. The average rate of return, giving effect to
straight-line depreciation on the investment. If required, round
your answer to one decimal place.
%
b. The cash payback period.
c. The net present value. Use the above table of the present value of an annuity of $1. Round to the nearest dollar. If required, use a minus sign to indicate negative net present value for current grading purpose.
Present value of annual net cash flows | $ |
Amount to be invested | $ |
Net present value | $ |
Answer-a)- Average rate of return = 10%.
Explanation= Accounting rate of return= (Annual net income/ Initial investment)*100
= ($16500/$165000)*100
= 10%
Where- Net income = Annual cash inflow- Annual depreciation
= $33000 - $16500
= $16500
Explanation- Straight line Method- Annual
Depreciation Expense = Cost of asset- Salvage value of asset/No. of useful life (years)
=($165000 - $0)/10 years
=$165000/10 years
= $16500
2)- Cash payback period = 5 years.
Explanation- Payback period is the time in which the initial cash outflow of an investment is expected to be recovered from the cash inflows generated by the investment. It is one of the simplest investment appraisal techniques.
In case when cash inflow are even, the formula to calculate payback period is:
Cash payback period =Initial investment / Cash Inflow per period
= $165000/$33000
= 5 years
3)- Net present value = $627.
Explanation-Net present value = Present value of cash inflows – Total outflows
= ($33000*5.019) - $165000
= $165627 - $165000
= $627