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# Prepared by Diane Tanner University of North Florida

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

2. Other Approaches Other methods used to make capital budgeting decisions include . . . • The Payback Period Method • Accounting Rate of Return Disadvantage No time value of money considered

3. What is it? Length of time it takes to recover the initial cost of an investment Two limitations Ignores cash inflows in years beyond the payback year Ignores the time value of money Payback Period Method How long will it take to get my money back?

4. Payback Method With Even Cash Flows \$60,000 \$22,000 Payback period = Investment required Net annual cash inflow Payback period = Kirk, Inc. wants to install an ice cream machine in its restaurant. It is expected to cost \$60,000 and has a 4-year life. Kirk thinks it will generate net annual cash inflows of \$22,000. Determine the payback period. = 2.73 years

5. Payback Method With UnEven Cash Flows Kirk, Inc. wants to install an ice cream machine in its restaurant. It is expected to cost \$60,000 and has a 4-year life. Kirk thinks it will generate net annual cash inflows of \$15,000 in year 1 with a 10% increase each year. Determine the payback period. 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

6. Payback Method With Uneven Cash Flows Payback period = 3.52 years

7. Evaluation of the Payback Method Ignores the time value of money Ignores cash flows after the payback period Short-comings of the Payback Period

8. Another capital budgeting approach Ignores the time value of money Does not consider timing of cash flows or net income Accounting Rate of Return (ARR) ARR = Average Net Income Average Investment

9. Calculating Average Net Income • Add net income for each year and divide by the number of years • Example: Net income for year 1 is \$10,000 with an increase of 12% per year expected for two more years • Year 2 = \$10,000*1.12 = \$11,200 • Year 3 = \$11,200*1.12 = \$12,544 • Average income = [\$10,000 + \$11,200 + \$12,544]/3 = \$11,248

10. Calculating Average Investment • Add beginning book value to ending book value and divide by two • Example: A machine costing \$115,000 with a salvage value of \$10,000 and an estimated life of 4 years is being considered. • Book value at beginning of life = \$115,000 • Book value at end of life = \$10,000 [\$115,000 + \$10,000]/2 = \$62,500

11. ARR Example Werth, Inc. has a cost of capital of 14% and a 30% tax rate. Werthis planning to buy equipment for \$90,000 which generates cash flows of \$160,000 over 2 years. The equipment has a salvage value of \$10,000. Revenues: Year 1: \$50,000 Year 2: \$95,000 Expenses: Year 1: \$38,000 Year 2: \$82,000

12. Solution to ARR Example Calculate net income for each year. Year 1Year 2 Revenues \$50,000 \$95,000 Expenses 38,00082,000 Net income \$12,000 \$13,000 ARR = Average Net Income/Average Investment [(\$12,000 + \$13,000)/2] [\$90,000+\$10,000]/2 = 25.00%

13. Disadvantages of ARR • 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

14. The End