Question

Average Rate of Return, Cash Payback Period, Net Present Value Method for a Service Company

Spanish Peaks Railroad Inc. is considering acquiring equipment at a cost of $1,250,000. The equipment has an estimated life of eight years and no residual value. It is expected to provide yearly net cash flows of $312,500. The company’s minimum desired rate of return for net present value analysis is 12%.

Present Value of an Annuity of $1 at Compound Interest
Year	6%	10%	12%	15%	20%
1	0.943	0.909	0.893	0.870	0.833
2	1.833	1.736	1.690	1.626	1.528
3	2.673	2.487	2.402	2.283	2.106
4	3.465	3.170	3.037	2.855	2.589
5	4.212	3.791	3.605	3.353	2.991
6	4.917	4.355	4.111	3.785	3.326
7	5.582	4.868	4.564	4.160	3.605
8	6.210	5.335	4.968	4.487	3.837
9	6.802	5.759	5.328	4.772	4.031
10	7.360	6.145	5.650	5.019	4.192

Compute the following:

a. The average rate of return, giving effect to straight-line depreciation on the investment. If required, round your answer to one decimal place.
%

b. The cash payback period.

c. The net present value. Use the above table of the present value of an annuity of $1. Round to the nearest dollar.

Present value of annual net cash flows	$
Amount to be invested	$
Net present value	$

Answer 1

Annual cashh inflows			312500
Less: Annual depreciation			156250
	(1250000/8)
Annual net income			156250
Divide: Average investment			625000
	(1250000*1/2)
Average rate of return			25%
Payback period: Investment / Annual cash inflows
		1250000/312500 = 4 years
Annual Cash inflows			312500
Annuity PVF at 12% for 8 years			4.968
Present value of inflows			1552500
Less: Investment			1250000
Net Present value			302500