The ABC company is thinking of purchasing a new luxury coach to sustain its prestige client business. The purchase cost of the vehicle, including license plates and delivery, is $120,000. The company anticipates that it will use the vehicle for five years and be able to sell it at the end of that period for $40,000. The revenue the company expects to generate using the coach is as follows:

By the end of year | net profit before depreciation ($) |

1
2 3 4 5 |
30,000
30,000 30,000 25,000 20,000 |

- What is the accounting rate of return for this investment?
- Workout the payback period for the investment proposed being considered by ABC company.

**Step 1 of 2**- In the question, it is given that ABC company is thinking of purchasing new luxury coach to sustain its prestige client business . The purchase cost of vehicle is $120,000. the life time of vehicle is for five years and at the end the value of vehicle would be $40,000.
- The accounting rate of return and payback period is to be calculated.
- A helpful capital budgeting metric to quickly determine the profitability of an investment is the accounting rate of return. Companies generally use average rate of return (ARR) to compare several projects and ascertain the expected rate of return of each project, or to assist in making investment or acquisition decisions whereas the time required to recoup an investment’s cost is referred to as the payback period. It’s the amount of time, put simply, that an investment takes to break even.
**Explanation:**- The percentage rate of return anticipated on an asset or investment, relative to the cost of the initial investment, is represented by the accounting rate of return (ARR) formula. The average rate of return (ARR) that can be expected over the course of a project or asset’s lifetime is calculated by dividing the asset’s average revenue by the company’s initial investment. The payback period is the amount of time needed to recover the cost of an investment. In simple terms, it’s the amount of time it takes for an investment to break even.
**Step 2 of 2**- A) The accounting rate of return is calculated by dividing the average annual accounting profit by the initial investment cost.
- Before calculating accounting rate of return, average annual accounting profit would be calculated as-
- Average annual accounting profit = $30,000+$30,000+$30,000+$25,000+$20,0005
- Average annual accounting profit =$135,0005
- Average annual accounting profit = $27,000
- Now average rate of return is calculated as –
- Average rate of return = $27,000120,000×100
- Average rate of return =0.225×100
- Average rate of return =22.5%
- B) The Payback Period is the time it takes for the initial investment to be recovered from the net cash inflows.
- Payback period = Initial investmentNet cash inflow per year
- Net cash flow per year :
- Year 1 – $30,000
- Year 2 -$30,000
- Year3 – $30,000
- Year 4 – $25,000
- Year 5 -$20,000
- Payback period = Initial investmentNet cash inflow per year
- initial investment = $120,000
- Payback period = $120,000$30,000+$30,000+$30,000+$25,000+$20,000
- Payback period = $120,000$1,350,000
- Payback period =0.888years
- Therefore, the payback period for the investment is approximately 0.89 years.
**Explanation:**- The average rate of return is computed by dividing the average annual accounting profit by the initial investment cost and payback period is computed by dividing the initial investment cost by annual cash flow.
**Final solution**- A) The average rate of return =22.5%
- b) The payback period for the investment is approximately 0.89 years.