Question

Exercise 25-8 Payback period and accounting rate of return on investment LO P1, P2 B2B Co. is considering the purchase of equipment that would allow the company to add a new product to its line. The equipment is expected to cost $216,000 with a 12-year life and no salvage value. It will be depreciated on a straight-line basis. The company expects to sell 86,400 units of the equipment's product each year. The expected annual income related to this equipment follows. $ 135,000 Sales Costs Materials, labor, and overhead (except depreciation on new equipment) Depreciation on new equipment Selling and administrative expenses Total costs and expenses Pretax income Income taxes (40%) Net income 72,000 18,000 13,500 103,500 31,500 12,600 18,900 $ 1. Compute the payback period. 2. Compute the accounting rate of return for this equipment.

Answer 1

Requirement 1:

Payback period: It helps to identify the time taken by the investment to cover the cost. It's decision criteria is "shorter period would be selected".

Payback Period = Cost of Investment / Annual Net cash flow

= $216,000 / $36,900

= 5.85 Years.

Hence, Payback period is 5.85 Years.

Workings:

Calculate the amount of net cash flow as follows:

Particulars	Amount
Annual After tax Income	$18,900
Add: Depreciation	$18,000
Annual net cash flow	$36,900

Requirement 2:

Accounting rate of return calculates the return on investment.

Accounting rate of return = Annual after-tax net Income / Annual average Investment

= $18,900 / $108,000

= 0.175 or 17.5%

Hence, Accounting rate of return is 17.5%.

Working:

Annual average Investment = Cost of Investment / 2

= $216,000 / 2

= $108,000