Question

Payback Period and Accounting Rate of Return: Equal Annual Operating Cash Flows with Disinvestment
Roopali is considering an investment proposal with the following cash flows:

Initial investment-depreciable assets	$28,000
Initial investment-working capital	4,000
Net cash inflows from operations (per year for 8 years)	8,000
Disinvestment-depreciable assets	4,000
Disinvestment-working capital	2,000

For parts b. and c., round answers to three decimal places, if applicable.

a. Determine the payback period.

4 years

b. Determine the accounting rate of return on initial investment

?

c. Determine the accounting rate of return on average investment

?

Answer 1

Solution a:

Payback Period = Total Initial Investment / Annual net cash inflows

= ($28,000 + $4,000) / $8,000 = $32,000/ $8,000 = 4 years

Solution b:

Annual Depreciation = (Investment in Depreciable assets - Disinvestment Depreciable assets)/useful life

= ($28,000 - $4,000)/ 8 years = $24,000/ 8  = $3,000

Annual Net Income = Annual Cash Inflows - Annual Depreciation = $8000 - $3000 = $5000

Accounting rate of return on initial investment = Annual net Income / Total Initial Investment = $5000 / ($28000+ $8000)

= $5000 / $32000 = 15.625%

Solution c:

Average Investment = (Total Initial Investment + Total Disinvestment)/2 = ($28000 +$4000 + $4000 +$2000) / 2

= $38000 / 2 = $19,000

Annual net Income = $5,000

Accounting rate of return on average investment = Average Net income / Average investment

= ($5,000/ $19,000) = 26.316%