Mastery Problem: Cash Payback and Average Rate of Return (Advanced) 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. 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 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 a dollar tomorrow. True or False: Considering the fact that most firms use methods from each category, it can be concluded that both categories have value. True Feedback Check My Work Hover over each underlined definition with your mouse to review characteristics of each category. Cash Payback Method This method identifies how long it will take (in years) to recover the initial investment . The particulars of the method vary depending on whether the cash flows from 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 $15,000 per year for 10 years. What is the payback period for this investment? If required, round your answer to two decimal places. Cash Payback Period = $ / $ years Feedback Check My Work Formula: Cash Payback Period = Initial Investment/Annual Cash Flow Payback Period (Uneven cash flows) 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 flows 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 flows are needed, only add the fraction of the year's cash flows 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. + 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 flow for that year. If Unrecovered Investment Annual Cash Flow Time Needed for Payback Unrecovered Investment Annual Cash Flow Time Needed for Payback Then 1 year Unrecovered Investment Annual Cash Flow for the Year Compute the time needed for payback for the following example assuming the investment required an up-front capital outlay of $100,000 and the uneven annual cash flows for each year are provided in the table. If an amount is zero, enter "0". For the time needed for payback, enter your answer to one decimal place, if less than one year (i.e. 0.2, 0.5, etc.). Unrecovered Investment Year Annual Cash Flow Time Needed for Payback (Beginning of year) 1 $100,000 2 3 4 $50,000 30,000 40,000 20,000 1 year 5 10,000 2 3 4 5 30,000 40,000 20,000 10,000 Total time needed for payback (to the nearest tenth of a year) Feedback Check My Work years Given the cash flow shown for each year, calculate the unrecovered investment (the amount remaining) for each year. If the year's cash flow does not deplete the unrecovered investment, then put a "1" in the column for time needed for payback. If the cash flow depletes the entire amount, then calculate the portion of the year that the unrecovered investment will take to be depleted. Once the unrecovered investment hits zero, leave it at zero for all remaining years. Average Rate of Return The average rate of return is another method that does not use present value and is commonly used in making capital investment decisions. Unlike the cash payback method, the average rate of return focuses on income rather than cash flow. Assume that the investment involves an initial outlay of $100,000 with a five-year useful life and no salvage value under straight-line depreciation. The revenues are as follows: Year 1 - $50,000, Year 2 - $30,000, Year 3 - $40,000, Year 4 - $20,000 and Year 5 - $10,000. Use the minus sign to indicate a net loss. If an amount is zero, enter "0". Year Year 1 Net Income (loss) 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) = $ Revenues Expenses Net Income Expenses Net Income Use the minus sign to indicate a net loss. If an amount is zero, enter "0". Year Year 1 Net Income (loss) 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) = $ Revenues Average Net Income = Average Rate of Return = 1.1.11.0 % Mastery Problem: Time Value of Money Time value of money Due to both interest earnings and the fact that money put to good use should generate additional funds above and beyond the original investment, money tomorrow will be worth less than money today. Simple interest Ross Co., a company that you regularly do business with, gives you a $11,000 note. The note is due in three years and pays simple interest of 9% annually. How much will Ross pay you at the end of that term? Note: Enter the interest rate as a decimal. (i.e. 15% would be entered as .15) Principal + (Principal + ($ Feedback X Rate X Time Total X X years Check My Work Remember, the interest is only computed on the principal amount. Compound interest With compound interest, the interest is added to principal in the calculation of interest in future periods. This addition of interest to the principal is called compounding. This differs from simple interest, in which interest is computed based upon only the principal. The frequency with which interest is compounded per year will dictate how many interest computations are required (i.e. annually is once, semi-annually is twice, and quarterly is four times). Imagine that Ross Co., fearing that you wouldn't take its deal, decides instead to offer you compound interest on the same $11,000 note. How much will Ross pay you at the end of three years if interest is compounded annually at a rate of 9%? If required, round your answers to the nearest cent. Principal Amount at Beginning of Year Year Annual Amount of Interest (Principal at Beginning of Year x 9%) Accumulated Amount at End of Year (Principal at Beginning of Year + Annual Amount of Interest) 1 $11,000 $990 $11,990 2 $11,990 $ 3