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 $144,000. The equipment has an estimated life of 10 years and no residual value. It is expected to provide yearly net cash flows of $72,000. 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. If required, use a minus sign to indicate negative net present value for current grading purpose.

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

Answer 1

• All working forms part of the answer
• Requirement [a]

A	Annual net cash flows	$72,000
B	Cost of equipment	$144,000
C	Resdiual value	$0
D	Life [years]	10
E = (B-C)/D	Annual Depreciation	$14,400
F = A - E	Annual net income	$57,600
G = (B+C)/2	Average investment	$72,000
H = (F/G) x 100	Average rate of return	80.0%

• [b]

A	Cost of equipment	$144,000
B	Annual net cash flows	$72,000
C = A/B	Cash Payback period	2

• [c]

A	Annual net cash flows	$72,000
B	PVA $1 at 12% for 10th period	5.65
C = A x B	Present value of annual net cash flows	$406,800
D	Amount to be invested	$144,000
E = C - D	Net Present value	$262,800