Question

Clyde Corp. is considering the purchase of a new piece of equipment. The cost savings from the equipment would result in an annual increase in cash flow of $101,100. The equipment will have an initial cost of $601,100 and have an 8 year life. The equipment has no salvage value. The hurdle rate is 8%. Ignore income taxes. (Future Value of $1, Present Value of $1, Future Value Annuity of $1, Present Value Annuity of $1.) (Use appropriate factor from the PV tables.)


a. What is the accounting rate of return? (Round your answer to 2 decimal places.)

b. What is the payback period? (Round your answer to 1 decimal place.)

c. What is the net present value? (Do not round intermediate calculations. Negative value should be indicated by a minus sign. Round your answer to nearest whole number.)

d. What would the net present value be with a 13% hurdle rate? (Do not round intermediate calculations. Negative value should be indicated by a minus sign. Round your answer to nearest whole number.)

e. Based on the NPV calculations, what would be the equipment's internal rate of return? (Round your answer to 2 decimal places.)

Answer 1

a. Accounting Rate of Return (ARR) is the average net income an asset is expected to generate divided by its average capital cost, expressed as an annual percentage.

Average Net Income = $101,100

Average investment = (601,100+0)/2 = $300,550

Therefore, Accounting Rate of Return = $101,100/$300,550 = 33.64%

b. The payback period is the time required to recover the initial cost of an investment. It is the number of years it would take to get back the initial investment made for a project. Therefore, as a technique of capital budgeting, the payback period will be used to compare projects and derive the number of years it takes to get back the initial investment. The project with the least number of years usually is selected.

Payback period = Cost of Investments / Annual Cash Flows = 601,100/101,100 = 5.95 years

c. Computation of Net Present Value with 8% interest rate:

Year	Annual flows	PV Factor@8%	NPV
	A	B	C=A*B
0	-$601,100	1	-$601,100.00
1	$101,100	0.92593	$93,611.11
2	$101,100	0.85734	$86,676.95
3	$101,100	0.79383	$80,256.44
4	$101,100	0.73503	$74,311.52
5	$101,100	0.68058	$68,806.96
6	$101,100	0.63017	$63,710.15
7	$101,100	0.58349	$58,990.88
8	$101,100	0.54027	$54,621.18
Net Present Value of Cash Flows from New Equipment			-$20,114.80

d. Computation of Net Present Value with 13% interest rate:

Year	Annual flows	PV Factor@13%	NPV
	A	B	C=A*B
0	-$601,100	1	-$601,100.00
1	$101,100	0.88496	$89,469.03
2	$101,100	0.78315	$79,176.13
3	$101,100	0.69305	$70,067.37
4	$101,100	0.61332	$62,006.52
5	$101,100	0.54276	$54,873.03
6	$101,100	0.48032	$48,560.20
7	$101,100	0.42506	$42,973.63
8	$101,100	0.37616	$38,029.76
Net Present Value of Cash Flows from New Equipment			-$115,944.32

e. The IRR is the discount rate at which the net present value (NPV) of future cash flows from an investment is equal to zero.

If we calculate using pen paper then we have to go for the hit and trial method.

Therefore, we are enclosing the calculation of IRR using Excel.

Period Cash Flow OT-$601,100.00 $101,100.00 $101,100.00 $101,100.00 $101,100.00 $101,100.00 $101,100.00 $101,100.00 8 $101,100.00 IRR IRR 7.11% =+IRR(Y6:Y140) IRR(values, guess])