Survey Of Accounting
Survey Of Accounting
4th Edition
ISBN: 9780077862374
Author: Edmonds, Thomas P.
Publisher: Mcgraw-hill Education,
Question
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Chapter 16, Problem 20P

a.

To determine

Ascertain the payback period and unadjusted rate of return (use average investment) for each alternative.

a.

Expert Solution
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Explanation of Solution

The annual rate of return method:

The annual rate of return is the amount of income which is earned over the life of the investment. It is used to measure the annual income as a percent of the annual investment of the business, and it is also known as the accounting rate of return.

Payback period:

Payback period is the expected time period which is required to recover the cost of investment. It is one of the capital investment method used by the management to evaluate the proposal of long-term investment (fixed assets) of the business.

Ascertain the payback period for each alternative as follows:

Alternative 1:

Payback period for alternative 1}=Cost of investmentCash flows per year (1)=$8,100$4,780=1.69 years

Alternative 2:

Payback period for alternative 2}=Cost of investmentCash flows per year (1)=$10,080$5,360=1.88 years

Ascertain the unadjusted rate of return for each alternative as follows:

Alternative 1:

Unadjusted rate of return = Average increase in net incomeAverage cost of investment=$2,080$4,050(6)×100=51.36%

Alternative 2:

Unadjusted rate of return = Average increase in net incomeAverage cost of investment=$2,840$5,040(7)×100=56.35%

Working note (1):

Calculate the amount of cash flow per year for both alternatives:

ParticularsAlternative 1Alternative 2
Cash revenue$12,400$17,000
Less: Operating expense1,8004,860
Depreciation expense5,400(4)5,040(5)
Income before tax5,2007,100
Income tax expense 1,040 (2)1,420 (3)
Net Income4,1605,680
Add: Depreciation  expense5,4005,040
Cash flow per year$9,560$10,720

Table (1)

Working note (2):

Calculate the amount of income tax expense for alternative 1:

Income tax expensefor alternative 1}=Rate of tax×Income before tax=20100×$5,200=$1,040

Working note (3):

Calculate the amount of income tax expense for alternative 2:

Income tax expensefor alternative 2}=Rate of tax×Income before tax=20100×$7,100=$1,420

Working note (4):

Calculate the amount of depreciation expense for alternative 1:

Depreciation expensefor alternative 1}=Acquisition cost – Salvage valueUseful life=$16,20003 Years=$5,400

Working note (5):

Calculate the amount of depreciation expense for alternative 2:

Depreciation expensefor alternative 2}=Acquisition cost – Salvage valueUseful life=$20,16004 Years=$5,040

Working note (6):

Calculate the average cost of investment of alternative 1.

Average cost of investment} = (Net cost of original investment2)=$8,1002=$4,050

Working note (7):

Calculate the average cost of investment of alternative 1.

Average cost of investment} = (Net cost of original investment2)=$10,0802=$5,040

b.

To determine

Indicate the investment alternative that is recommendable and explain the reason behind it.

b.

Expert Solution
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Explanation of Solution

Indicate the investment alternative that is recommendable and explain the reason behind it as follows:

From the above calculation it is clear that alternative 2 appears better than alternative 1. This is because alternative 2 has a longer useful life and higher unadjusted rate of return, while alternative 1 has a shorter useful life and shorter unadjusted rate of return.

If the investor prefers shorter payback period then the investor can go for alternative 1 since it provide a quicker payback than alternative 2.

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