Question

Crichton Publications uses the accounting rate of return method to evaluate proposed capital investments. The company’s desired rate of return is 15.0%. The project being evaluated involves a new product that will have a three-year life. The investment required is $330,000, which consists of a $275,000 machine, and inventories and accounts receivable totaling $55,000. The machine will have a useful life of three years and a salvage value of $157,500. The salvage value will be received during the fourth year, and the inventories and accounts receivable related to the product also will be converted back to cash in the fourth year. Accrual accounting net income from the product will be $90,000 per year, before depreciation expense, for each of the three years. Because of the time lag between selling the product and collecting the accounts receivable, cash flows from the product will be as follows: Use Table 6-4. (Use appropriate factor(s) from the tables provided. Round the PV factors to 4 decimals.) 1st year $ 45,000 2nd year 75,000 3rd year 90,000 4th year 63,000 Required: a-1. Calculate the accounting rate of return for the first year of the product. Assume straight-line depreciation. (Do not round intermediate calculations. Round your answer to 2 decimal places.) a-2. Based on this analysis, would the investment be made? Yes No b-1. Calculate the net present value of the product using a discount rate of 15.0% and assuming that cash flows occur at the end of the respective years. (Negative amounts should be indicated by a minus sign. Do not round intermediate calculations.)

Answer 1

a-1.Accounting rate of return for the first year of the product--assuming straight-line depreciation
Year	0	1	2	3	4
Capital investment	-275000
Cash inflows		45000	75000	90000	63000
Annual depreciation(275000-157500)/3		-39166.67	-39166.67	-39166.67
Accounting Income		5833.33	35833.33	50833.33	63000
Accounting rate of return(ARR) on the initai capital investment (Accg.Income/275000)		2.12%	13.03%	18.48%	22.91%
Average ARR=( 2.12+13.03+18.48+22.91)/4=
	14.14%
ARR for the 1st year	2.12%
Av. ARR	14.14%
a--2...As the reqd. rate of return = 15%, the project cannot be accepted.
b.1
NPV using 15% discount rate
Year	0	1	2	3	4
Capital investment	-275000
Working capitalIntroduced & recovered	-55000				55000
Cash inflows		45000	75000	90000	63000
Salvage					157500
Net annual cash flows	-330000	45000	75000	90000	275500
PV F at 15%	1	0.86957	0.75614	0.65752	0.57175
PV of cash flows at 15%	-330000	39130.43	56710.78	59176.46	157518
NPV	-17464.3
As the NPV is negaive at the reqd. rate of return of 15%, the project cannot be accepted.