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Accounting

27th Edition
WARREN + 5 others
ISBN: 9781337272094

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BuyFindarrow_forward

Accounting

27th Edition
WARREN + 5 others
ISBN: 9781337272094
Textbook Problem

Average rate of return, cash payback period, net present value method for a service company

 Bi-Coastal Railroad Inc. is considering acquiring equipment at a cost of $520,000. The equipment has an estimated life of eight years and no residual value. It is expected to provide yearly net cash flows of $104,000. The company’s minimum desired rate of return for net present value analysis is 10%.

 Compute the following:

  1. a. The average rate of return, assuming the annual earnings are equal to the net cash flows less the annual depreciation expense on the equipment.
  2. b. The cash payback period.
  3. c. The net present value. Use the present value of an annuity of $1 table appearing in this chapter (Exhibit 5). Round to the nearest dollar.

a.

To determine

Average rate of return method:

Average rate of return is the amount of income which is earned over the life of the investment. It is used to measure the average income as a percent of the average investment of the business, and it is also known as the accounting rate of return.

The average rate of return is computed as follows:

Average rate of return =Estimated average annual incomeAverage investment

Cash payback method:

Cash payback period is the expected time period which is required to recover the cost of investment. It is one of the capital investment method used by the management to evaluate the long-term investment (fixed assets) of the business.

In simple, the cash payback period is computed as follows:

Cash payback period =Initial costAnnual net cash inflow

Net present value method:

Net present value method is the method which is used to compare the initial cash outflow of investment with the present value of its cash inflows. In the net present value, the interest rate is desired by the business based on the net income from the investment, and it is also called as the discounted cash flow method.

To determine: The average rate of return on the equipment.

Explanation

The average rate of return on the equipment is as follows:

Here, the computed estimated average annual income = $39,000 (2), and the computed average investment = $260,000 (3).

Average rate of return =Estimated average annual incomeAverage investment=$39,000$260,000=0.15In percentage,  0.15×100 = 15%

Hence, average rate of return is 15%.

Working note:

1. Calculate the amount of annual depreciation

Annual depreciation=Cost of equipmentResidual valueUseful life of the asset=$520,000$08 years=$65,000 (1)

2

b.

To determine
The cash payback period for the equipment.

(c)

To determine

To calculate: The net present value of the investment.

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