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Payback Period and Accounting Rate of Return Managerial Accounting Prepared by Diane Tanner University of North Florida Chapter 18

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Two More Capital Budgeting Methods The payback period method How long will it take to recover the cash investment? Accounting rate of return What is the return on profit generated by the investment? Key Disadvantage: No time value of money consideration Key Disadvantage: No time value of money consideration

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Payback Period Method Indicates the length of time in years it takes to recover the initial cost of an investment Limitations 1.Ignores cash inflows in years beyond the payback year 2.Ignores the timing of cash flows within the payback period 3.Ignores the time value of money

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Payback Period Method Two approaches Short cut method Effective when the operating cash flows are expected to be the same each year 4 Payback period= Initial investment Annual operating cash flow amount Unequal cash flows method Effective when the annual operating cash flows differ Amount to recover - Cash flows of year 1 - Cash flows of year 2 - Cash flows of year 3, etc.. = Cash flows to recover during next year Portion to recover during next year = Cash flows to recover during next year Annual operating cash flow for next year

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Payback Method With Even Cash Flows Kirk, Inc. wants to install an ice cream machine in its restaurant. It is expected to cost $60,000, has a 4-year life, and a $3,000 salvage value. Kirk thinks it will generate net annual cash inflows of $22,000. Determine the payback period. = 2.73 years $60,000 $22,000 Payback period= Initial investment Annual operating cash flow amount Interpretation: Kirk expects to recover its cash investment in approximately 2.73 years. Evaluation: Because the cash is expected to be recovered in less than 4 years, the investment is acceptable based on this analysis.

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Payback Method With Uneven Cash Flows Step 1: Determine the annual cash flows: Year 1 = $15,000 Year 2 = $15,000*1.10 = $16,500 Year 3 = $16,500*1.10 = $18,150 Year 4 = $18,150*1.10 = $19,965 payback period. Kirk, Inc. wants to install an ice cream machine with an expected cost of $60,000, a 4-year life, a $3,000 salvage value, and net annual cash inflows of $15,000 in year 1 with a 10% increase each year. Determine the payback period. Step 2: Track recoveries by year: Amount to be recovered$60,000 Recovered in year 1(15,000) 45,000 Recovered in year 2(16,500) 28,500 Recovered in year 3(18,150) Balance at end of year 3$10,350 Proration of year 4: $10,350/$19,965 = 0.5184 Payback period = 3.52 years Interpretation: Kirk expects to recover its cash investment in approximately 3.52 years.

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Limitations Does not consider timing of cash flows because cash flows are averaged together Views profits near the beginning of the useful life equal to those at the end Ignores the time value of money Limitations Does not consider timing of cash flows because cash flows are averaged together Views profits near the beginning of the useful life equal to those at the end Ignores the time value of money Accounting Rate of Return (ARR) Determines the annual return on profit expected Ignores the time value of money Does not consider the timing of cash flows or the timing of net income ARR = Average net income Average investment Add net income for each year and divide by the number of years Add beginning book value to ending book value and divide by 2

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ARR Example Werth, Inc. has a cost of capital of 14% and a 30% tax rate. Werth is planning to buy equipment for $90,000 which is has a salvage value of $8,000. Estimated net income for year 1 is $7,000, year 2 is $18,000, and year 3 is $11,000. The required rate of return is 18%. ARR = Average net income Average investment [($7,000 + $18,000 + $11,000) / 3] [$90,000 + $8,000] / 2 = 24.45% = Interpretation: Werth expects to generate a return on profit of 24.45% each year as a result of acquiring the equipment. Evaluation: Because the return is greater than the RRR of 18%, the investment is acceptable.

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9 The End

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