Chapter 18
Managerial Accounting
Payback Period and
Accounting Rate of
Return
Prepared by Diane Tanner
University of North Florida
Two More Capital Budgeting Methods
 The payback period method
 How long will it take to recover the cash
investment?
 Accounting rate of return
 What is the return on profit generated by the
investment?
Key Disadvantage:
No time value of money consideration
Payback Period Method
 Indicates the length of time in years it takes
to recover the initial cost of an investment
 Limitations
1. Ignores cash inflows in years beyond the
payback year
2. Ignores the timing of cash flows within the
payback period
3. Ignores the time value of money
Payback Period Method
 Two approaches
 Short cut method
 Effective when the operating cash flows are expected to
be the same each year
Payback period =
Initial investment
Annual operating cash flow amount
 Unequal cash flows method
 Effective when the annual operating cash flows differ
Amount to recover
- Cash flows of year 1
- Cash flows of year 2
- Cash flows of year 3, etc.
.
= Cash flows to recover during next year
Portion to recover
during next year
=
Cash flows to recover during next year
Annual operating cash flow for next year
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Payback Method With Even Cash Flows
Kirk, Inc. wants to install an ice cream machine in its restaurant.
It is expected to cost $60,000, has a 4-year life, and a $3,000
salvage value. Kirk thinks it will generate net annual cash
inflows of $22,000. Determine the payback period.
Initial investment
Payback period =
Annual operating cash flow amount
$60,000
= 2.73 years
$22,000
Interpretation: Kirk expects to recover its cash investment in
approximately 2.73 years.
Evaluation: Because the cash is expected to be recovered in less
than 4 years, the investment is acceptable based on this analysis.
Payback Method With Uneven Cash Flows
Kirk, Inc. wants to install an ice cream machine with an expected cost
of $60,000, a 4-year life, a $3,000 salvage value, and net annual cash
inflows of $15,000 in year 1 with a 10% increase each year.
Determine the payback period.
Step 1:
Determine the annual cash flows:
Year 1 = $15,000
Year 2 = $15,000*1.10 = $16,500
Year 3 = $16,500*1.10 = $18,150
Year 4 = $18,150*1.10 = $19,965
Interpretation: Kirk expects to
recover its cash investment in
approximately 3.52 years.
Step 2: Track recoveries by year:
Amount to be recovered
$60,000
Recovered in year 1
(15,000)
45,000
Recovered in year 2
(16,500)
28,500
Recovered in year 3
(18,150)
Balance at end of year 3
$10,350
Proration of year 4:
$10,350/$19,965 = 0.5184
Payback period = 3.52 years
Accounting Rate of Return (ARR)
 Determines the annual return on profit expected
 Ignores the time value of money
 Does not consider the timing of cash flows or the timing
of net income
Add net income for each
ARR = Average net income
Average investment
year and divide by the
number of years
Add beginning book value to
ending book value and
divide by 2
Limitations
 Does not consider timing of cash flows because cash flows are
averaged together
 Views profits near the beginning of the useful life equal to
those at the end
 Ignores the time value of money
ARR Example
Werth, Inc. has a cost of capital of 14% and a 30% tax rate.
Werth is planning to buy equipment for $90,000 which is has a
salvage value of $8,000. Estimated net income for year 1 is
$7,000, year 2 is $18,000, and year 3 is $11,000. The required
rate of return is 18%.
ARR = Average net income
Average investment
=
[($7,000 + $18,000 + $11,000) / 3]
= 24.45%
[$90,000 + $8,000] / 2
Interpretation: Werth expects to generate a return on profit of
24.45% each year as a result of acquiring the equipment.
Evaluation: Because the return is greater than the RRR of 18%,
the investment is acceptable.
The End
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