Exercise-20 (Payback and accounting rate of return method)

The Euro Transport company wants to purchase a new truck. The truck would cost $225,000 and its salvage value would be 10% at the end of its 20-year useful life. The annual estimated revenues and costs associated with the new truck are given below:

exercise-20-cbt-img1

Required:

  1. Compute payback period of the truck. Is the investment in new truck desirable if maximum desired payback period of the Euro Transport company is 5 years?
  2. Compute the accounting rate of return promised by the truck. Would the Euro Transport company be interested in new truck if minimum required accounting rate of return is 12%?

Solution:

(1). Payback Analysis:

Payback period = Cost of the truck / Net annual cash inflows

= $225,000/$45,000*

= 5 years

*Depreciation is a non-cash expense and has, therefore, been added back to the net operating income to obtain net annual cash inflows.

Because the payback period of the truck is equal to the maximum desired payback period of the Euro Transport company, the investment is desirable.

(2). Accounting rate of return Analysis:

Accounting rate of return = Incremental net operating income/Initial investment

= $34,875/$225,000

= 15.5%

The accounting rate of return promised by the truck is more than the accounting rate of return of the Euro Transport company. The investment in new truck is, therefore, desirable according to accounting rate of return analysis.

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4 Comments on Exercise-20 (Payback and accounting rate of return method)

  1. shankar

    For two projects if I am to choose one as a better option and Payback period (PBP) and accounting rate of return (ARR) show different results for those 2 projects which result should I choose PBP or ARR?

  2. Accounting For Management

    The payback period method focuses on the cash that you periodically receive from a project whereas accounting rate of return (ARR) method focuses on expected net accounting income of the project. If your firm experiences frequent cash shortages and you need a quick recovery of the cash invested at the start of the project, you would certainly calculate the payback period before undertaking the project. On the other hand, if your intention to undertake the project is to increase your net operating income for a long period of time, you would consider the use of accounting rate of return (ARR) method.

    In practice, however, companies normally do not depend on a single method. They use a combination of investment evaluation methods.

    Also read:
    http://www.accountingformanagement.org/capital-rationing-process/

    Hope this helps.

  3. zenebe

    its helping me much, i now feeling confidence for the exam, thanks really.

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