Question

Problem 24-1A Computing payback period, accounting rate of return, and net present value LO P1, P2, P3

Factor Company is planning to add a new product to its line. To manufacture this product, the company needs to buy a new machine at a $483,000 cost with an expected four-year life and a $15,000 salvage value. All sales are for cash, and all costs are out-of-pocket, except for depreciation on the new machine. Additional information includes the following. (PV of $1, FV of $1, PVA of $1, and FVA of $1) (Use appropriate factor(s) from the tables provided.)

Expected annual sales of new product	$	1,960,000
Expected annual costs of new product
Direct materials		485,000
Direct labor		677,000
Overhead (excluding straight-line depreciation on new machine)		336,000
Selling and administrative expenses		148,000
Income taxes		34	%

Required:
1. Compute straight-line depreciation for each year of this new machine’s life.
2. Determine expected net income and net cash flow for each year of this machine’s life.
3. Compute this machine’s payback period, assuming that cash flows occur evenly throughout each year.
4. Compute this machine’s accounting rate of return, assuming that income is earned evenly throughout each year.
5. Compute the net present value for this machine using a discount rate of 8% and assuming that cash flows occur at each year-end. (Hint: Salvage value is a cash inflow at the end of the asset’s life.)

Answer 1

1.Straight Line Depreciation

Straight Line Depreciation for each year = [Cost of the machine – Salvage Value] / Useful life

= [$483,000 - $15,000] / 4 Years

= $117,000

2.Expected Net Income and Net cash Flow

EXPECTED NET INCOME		Amount ($)
Revenues
Sales		1,960,000
Expenses
Direct Materials	(485,000)
Direct Labor	(677,000)
Overhead	(336,000)
Straight Line Depreciation	(117,000)
Selling and administrative	(148,000)	(1,763,000)
Income Before Taxes		197,000
Income Tax Expense at 34%		(66,980)
Net Income		130,020
EXPECTED CASH FLOW
Net Income		130,020
Add: Straight Line Depreciation		117,000
Expected Cash Flow		247,020

3.Payback Period

Payback Period
Numerator	/	Denominator	=	Payback Period
Initial Investment	/	Annual Net Cash Flow	=	Payback Period
$483,000	/	$247,020	=	1.96 Years

4.Accounting Rate of return

Accounting Rate of return
Numerator	/	Denominator	=	Accounting Rate of return
Net Income	/	Annual average Investment	=	Accounting Rate of return
$130,020	/	$249,000	=	52.22%

Annual average Investment = [Initial Investment + Salvage Value] / 2

= [$483,000 + $15,000] / 2

= $249,000

Requirement 5 –Net Present Value

Chart values are based on
	n =	4 Years
	i =	8.00%
Cash flow	Select chart	Amount	PV Factor	Present Value
Annual cash flow	Present value of annuity of $1	247,020	3.3121	818,154.94
Residual Value	Present Value of $1	15,000	0.7350	11,025.00
	Present Value of cash inflows			829,179.94
	Present Value of cash outflows			(483,000.00)
	Net Present Value			346,179.94

NOTE

-The formula for calculating the Present Value Annuity Inflow Factor (PVIFA) is [{1 - (1 / (1 + r)ⁿ} / r], where “r” is the Discount Rate/Cost of capital and “n” is the number of years.

-The formula for calculating the Present Value Inflow Factor (PVIF) is [1 / (1 + r)ⁿ], where “r” is the Discount Rate/Cost of capital and “n” is the number of years.