Question

Accounting Rate of Return Each of the following scenarios is independent. Assume that all cash flows are after-tax cash flows. Cobre Company is considering the purchase of new equipment that will speed up the process for extracting copper. The equipment will cost $3,700,000 and have a life of 5 years with no expected salvage value. The expected cash flows associated with the project are as follows: Year Cash Revenues Cash Expenses 1 $6,000,000 $4,800,000 2 6,000,000 4,800,000 3 6,000,000 4,800,000 4 6,000,000 4,800,000 5 6,000,000 4,800,000 Emily Hansen is considering investing in one of the following two projects. Either project will require an investment of $75,000. The expected cash revenues minus cash expenses for the two projects follow. Assume each project is depreciable. Year Project A Project B 1 $22,500 $22,500 2 30,000 30,000 3 45,000 45,000 4 75,000 22,500 5 75,000 22,500 Suppose that a project has an ARR of 30% (based on initial investment) and that the average net income of the project is $120,000. Suppose that a project has an ARR of 50% and that the investment is $200,000.

Required: 1. Compute the ARR on the new equipment that Cobre Company is considering. Round your answer to one decimal place. % 2. Conceptual Connection: Which project should Emily Hansen choose based on the ARR? Notice that the payback period is the same for both investments (thus equally preferred). Unlike the payback period, explain why ARR correctly signals that one project should be preferred over the other. ARR Project A 46 % Project B 18 % Based on the ARR, Emily Hansen chosen Project A . 3. How much did the company in Scenario c invest in the project? Round your answer to the nearest whole dollar. $ 4. What is the average net income earned by the project in Scenario d?

Answer 1

1) COBRE COMPANY
COST OF EQUIPMENT ($)		37,00,000
LIFE IN YRS		5
SALVAGE VALUE		0
EXPECTED CASH FLOW
YEAR	CASH REVENUE	CASH EXPENSES	NET CASH FLOW
1	6000000	4800000	1200000
2	6000000	4800000	1200000
3	6000000	4800000	1200000
4	6000000	4800000	1200000
5	6000000	4800000	1200000
TOTAL $	30000000	24000000	6000000
AVERAGE INCOME =		NET CASH FLOW/5	1200000
NET INITIAL INVESTMENT			37,00,000
ACCOUNTING RATE OF RETURN=AV. INCOME/NET INITIAL . INVESTMENT
ACCOUNTING RATE OF RETURN (%)			32.4
2) EMILY HANSEN
	PROJECT A	PROJECT B
INVESTMENT ($)	75000	75000
YEAR	NET CASH INFLOW	NET CASH INFLOW
1	22500	22500
2	30000	30000
3	45000	45000
4	75000	22500
5	75000	22500
TOTAL $	247500	142500
AV. INCOME $	49500	28500
NET INITIAL INVESTMENT $	75000	75000
ARR %	66	38
BASED ON ARR, EMILY HANSEN SHOULD CHOOSE PROJECT A.
Superiority of ARR over payback period
i) Pay back period completely ignores all cash inflow after the pay back period.
ii)Pay back method does not take into account the entire life of the project during which
cash flow are generated. As a result, projects with larger cash inflows in the latter part of
their lives may be rejected in favour of less profitable projects which happens to generate
a larger proportion of their cash inflows in the earlier part of their lives.
3)
ARR(based on initial investment)		30%
AV. NET INCOME ($)		120000
INVESTMENT ($)		?
ARR=AV. NET INCOME/NET INVESTMENT
NET INVESTMENT ($)		400000
4)
ARR		50%
INVESTMENT ($)		200000
AV. NET INCOME		?
ARR=AV. NET INCOME/NET INVESTMENT
AV. NET INCOME $		100000