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

By: Rashid Javed | Updated on: September 8th, 2022

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.

Leave a comment