Question

Gibson rentals can purchase a van that costs 144,00

Exercise 16-15 Computing the payback period and unadjusted rate of return for the same investment pportunity LO 16-4 Gibson Rentals can purchase a van that costs $140.000; it has an expected useful life of five years and no salvage value. Gibson uses straight-line depreciation. Expected revenue is $51,870 per year. Assume that depreciation is the only expense associated with this investment Required a. Determine the payback period. (Round your answer to 1 decimal place.) b. Determine the unadjusted rate of return based on the average cost of the investment (Round your answer to 1 decimal place. (ie.. .234 should be entered as 23.4).) a. Payback period b. Unadjusted rate of return

Answer 1

(a) Payback period = Initial cash outlay / Net cash inflow per year

= $ 140,000 / $ 51,870

= 2.699 i.e. 2.7 years

(b) Unadjusted rate of return is calculated by dividing increase in future income by initial investment. The word unadjusted means that it does not take into consideration the time value of money.

Average cost of the investment = $ 140,000 /2 = $ 70,000

Increase in future net income = $ 51,870 - ($ 140,000 / 5yrs) = $ 23,870

Unadjusted rate of return = Increase in future net income / Average cost of the investment

= $ 23,870/ $ 70,000 * 100

= 34.1%

Depreciation is a non-cash expense and has therefore been ignored while calculating the payback period of the project. However, the same has been considered as a deduction while calculating the unadjusted rate of return.