chapter 25#2

Blueprint Problem: Payback and average rate of return Companies use capital investment analysis to evaluate long-term investments. Capital investment evaluation methods that do not use present values are (1) Average rate of return method and (2) Cash payback method. Non-Discounting Models One type of model used to assess the viability of a potential capital investment is known as a non-discounting model. The primary difference between a discounting model and a non-discounting model is that the latter take the time value of money into account. The basic premise of the time value of money is that a dollar today is worth a dollar tomorrow. True or False: Considering the fact that most firms use both discounting and non-discounting models, it can be concluded that both models have value. Hide Feedback Correct Check My Work Feedback Hover over each underlined definition with your mouse to review that characteristics of the discounting model. Payback Period This is one useful non-discounting method for evaluating capital investment decisions. The particulars of the method vary depending on whether the cash flows from an investment are even or uneven. The primary information transmitted by the payback period method is how long it will take (in years) to recover the . Payback Period (Even cash flows) Suppose that a particular investment required an up-front capital outlay of $100,000. This investment is expected to yield cash flows of $40,000 per year for 10 years. What is the payback period for this investment? If required, round your answer to two decimal places. Formula: Payback Period = Initial Investment/Annual Cash Flow Payback Period = $ / $ = years Hide Feedback Partially Correct Check My Work Feedback Hover over the underlined definitions with your mouse to review the characteristics of the Payback Period model. Average Rate of Return The average rate of return is another non-discounting financial model commonly used in making capital investment decisions. Unlike the payback period model, the average rate of return uses income rather than cash flows. The average rate of return is computed as follows: Estimated Average Annual Income/Average Investment. Assuming straight-line depreciation, the average investment is as ( Initial Cost + Residual Value)/2. Assume the investment has an initial outlay of $100,000 with a five-year useful life and no residual value under straight-line depreciation. The revenues are as follows: ( Year 1: $20,000, Year 2: $30,000, Year 3: $40,000, Year 4: $50,000 and Year 5: $60,000.) Use the minus sign to indicate a net loss. If an amount is zero, enter "0". If required, enter the average rate of return as a decimal (i.e. 0.3). Year Revenues Expenses Net Income Year 1 Net Income (loss) = $20,000 - $20,000 = $ Year 2 Net Income (loss) = - = Year 3 Net Income (loss) = - = Year 4 Net Income (loss) = - = Year 5 Net Income (loss) = - = Total Net Income (five years) = $ Average Net Income = $ = $ Average Rate of Return = $ =