Chapter 16, Problem 55P

1.

To determine

Calculate the payback period for the given proposal.

Explanation of Solution

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. But payback method has high risk than other method, because it does not follow the time value of money concept in valuing the cash inflows.

Calculate the payback period for the given proposal as follows:

Initial investment after tax = $120,000.

Year	Incremental cash flow	Accumulated cash flow
1	$ 40,000	$40,000
2	$40,000	$80,000 $\left(\$40,000+\$40,000\right)$
3	$40,000	$120,000 $\left(\$80,000+\$40,000\right)$
4	$38,000	$158,000 $\left(\$120,000+\$38,000\right)$
5	$37,000	$195,000 $\left(\$158,000+\$37,000\right)$

Table (1)

Conclusion

Therefore, the payback period for the given proposal is 3 years.

2.

To determine

Calculate the accounting rate of return for the given proposal using initial investment.

Explanation of Solution

Accounting rate of return method: Accounting rate of return is the amount of income which is earned over the life of the investment. It is used to measure the average income as a percent of the average investment of the business, and it is also known as the average rate of return.

Calculate the accounting rate of return for the given proposal using initial investment as follows:

$\begin{array}{c}\text{Accounting rate of return =}\frac{\text{Average cash inflow}}{\text{Initial investment}}\times 100\\ =\frac{\$15,000(3)}{\$120,000}\times 100\\ =12.5\%\end{array}$

Working note (1):

Calculate the average incremental revenue.

$\begin{array}{c}\begin{array}{l}\text{Average incremental}\\ \text{ revenue}\end{array}\}\text{ = }\frac{\text{Incremental revenue for five years}}{5}\\ =\frac{\left(\begin{array}{l}\$70,000+\$72,000+\$74,000\\ +\$76,000+\$78,000\end{array}\right)}{5}\\ =\$74,000\end{array}$

Working note (2):

Calculate the average incremental expense.

$\begin{array}{c}\begin{array}{l}\text{Average incremental}\\ \text{expense}\end{array}\}\text{ = }\frac{\left(\begin{array}{l}\text{Incremental expenes or five years}-\\ \text{Depreciation expen}\end{array}\right)\text{se}}{5}\\ =\frac{\left(\begin{array}{l}\$30,000+\$32,000+\$34,000\\ +\$38,000+\$41,000-\$24,000\end{array}\right)}{5}\\ =\$59,000\end{array}$

Working note (3):

Calculate the average cash inflow.

$\begin{array}{c}\text{Average cash inflow =}\left(\begin{array}{l}\text{ Average incremental revenue}-\\ \text{Average incremental expense}\end{array}\right)\\ =\left(\$74,000(1)-\$59,000(2)\right)\\ =\$15,000\end{array}$

3.

To determine

Calculate the accounting rate of return for the given proposal using average investment.

Explanation of Solution

Calculate the accounting rate of return for the given proposal using average investment as follows:

$\begin{array}{c}\text{Accounting rate of return =}\frac{\text{Average cash inflow}}{\text{Initial investment}}\times 100\\ =\frac{\$15,000(3)}{\$60,000(4)}\times 100\\ =25\%\end{array}$

Working note (4):

Calculate the average investment.

$\begin{array}{c}\text{Average investment = }\frac{\text{Initial invesment }}{2}\\ =\frac{\$120,000}{2}\\ =\$60,000\end{array}$

4.

To determine

Explain the reason why the discounted cash flow methods are superior to the payback and accounting rate of return.

Explanation of Solution

Net present value method (NVP): Net present value method is the method which is used to compare the initial cash outflow of investment with the present value of its cash inflows. In the net present value, the interest rate is desired by the business based on the net income from the investment, and it is also called as the discounted cash flow method.

Explain the reason why the discounted cash flow methods are superior to the payback and accounting rate of return as follows:

Discounted cash flow method reflects time value of money, and payback and accounting rate of return does not use the present value concept in valuing cash flows occurring in the different time period. Hence, the managerial accountants believe that the discounted cash flow methods are superior to the payback and accounting rate of return.

5.

To determine

Explain whether the activity of board’s chairperson is ethical or not.

Explanation of Solution

No, the activity of board’s chairperson is not ethical because chairperson should provide fair and objective information about the project and management should evaluate and choose the best alternative based on the high return.