Mastery Problem: Cash Payback and Average Rate of Return (Advanced) Companies use capital investment analysis to evaluate longaterrn investments. Capital investment evaluation methods that do not use present values are (1) Average rate of return method and (2) Cash payback method. Methods that do not use present value One category of capital Investment evaluation methods does not use present value. The primary difference between the category of methods that do use present value and this category is that this category does not V if take the time value of money into account. The basic premise of the time value of money is that a dollar today is worth more than V J a dollar tomorrow. True or False: Considering the fact that most rms use methods from each category, it can be concluded that both categories have value. True V 4 Feedback "' Check My Work Hover over each underlined denition with your mouse to review characteristics of each category. Cash Payback Method This method identies how long it will take (in years) to recover the initial investment ' VI . The particulars oic the method vary depending on whether the cash Flows i'rom an investment are even or uneven. Cash Payback Method (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 $45,000 per year for 10 years. What is the payback period for this investment? It required, round your answer to two decimal places. .l l..l l l l ) payback period for this investment? If required. round your answer to two decimal places. Cash Payback Period = $l l :' 55' I = l years Feedback Check My Work Formula: Cash Payback Period = initial Investnienti'Annual Cash Flow Payback Period (Uneven cash flows) When the annual cash flows are unequal, the payback period is computed by adding the annual cash flows until such time as the original Investment is recovered. If a fraction of a year is needed, it is assumed that cash flows occur evenly within each year. The steps for determining the payback period with uneven cash ows is as follows: 1. Add the annual cash flows to one another until the investment is recovered. 2. For each full year's worth of cash flows consumed, add that year to your calculation for total payback years. 3. If you arrive at a point where only part of the year's cash ows are needed, only add the traction of the year's cash ows relevant to recovering the initial investment to the total payback years. 4. If the unrecovered investment is greater than the annual cash flow, the payback period is "1". If the unrecovered investment is less than the annual cash flow the time needed For payback is computed by dividing the unrecovered investment by the annual cash flow for than year. -i Explanation of Time Needed for Payback With uneven cash flows Note: For each year in which the unrecovered investment meets or exceeds the annual cash flow, this is 1. For years in which the annual cash flow exceeds the unrecovered investment, this is the unrecovered investment divided by the annual cash ow for that year. H o-' -l T ('D 3 Unrecovered Annual Time Needed 2 = 1 year Investment Cash Flow for Payback Unrecovered Annual Time Needed Unrecovered Investment Year 4 Net Income (loss) = C] 7 :l Year 5 Net Income (loss) = mm mm; Total Net Income (five years) : 35:] Average Net Income = Average Rate of Return : Q5 :1 :l' :l