Question

1. Accounting Rate of Return

   Each of the following scenarios is independent. Assume that all cash flows are after-tax cash flows.

   1. 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

   2. 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

   3. Suppose that a project has an ARR of 30% (based on initial investment) and that the average net income of the project is $220,000.
   4. 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	%
   Project B	%

   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?
   $

   Feedback

   Partially correct

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1. Net Present Value

   Use Exhibit 12B.1 and Exhibit 12B.2 to locate the present value of an annuity of $1, which is the amount to be multiplied times the future annual cash flow amount.

   Each of the following scenarios is independent. Assume that all cash flows are after-tax cash flows.

   1. Campbell Manufacturing is considering the purchase of a new welding system. The cash benefits will be $480,000 per year. The system costs $2,150,000 and will last 10 years.
   2. Evee Cardenas is interested in investing in a women's specialty shop. The cost of the investment is $330,000. She estimates that the return from owning her own shop will be $40,000 per year. She estimates that the shop will have a useful life of 6 years.
   3. Barker Company calculated the NPV of a project and found it to be $63,900. The project's life was estimated to be 8 years. The required rate of return used for the NPV calculation was 10%. The project was expected to produce annual after-tax cash flows of $135,000.

   Required:

   1. Compute the NPV for Campbell Manufacturing, assuming a discount rate of 12%. If required, round all present value calculations to the nearest dollar. Use the minus sign to indicate a negative NPV.
   $

   Should the company buy the new welding system?
   Yes

   2. Conceptual Connection: Assuming a required rate of return of 8%, calculate the NPV for Evee Cardenas' investment. Round to the nearest dollar. If required, round all present value calculations to the nearest dollar. Use the minus sign to indicate a negative NPV.
   $

   Should she invest?
   No

   What if the estimated return was $135,000 per year? Calculate the new NPV for Evee Cardenas' investment. Would this affect the decision? What does this tell you about your analysis? Round to the nearest dollar.
   $

   The shop should now be purchased. This reveals that the decision to accept or reject in this case is affected by differences in estimated cash flow

   3. What was the required investment for Barker Company's project? Round to the nearest dollar. If required, round all present value calculations to the nearest dollar.
   $

   Feedback

   Net Present Value (NPV): NPV = P - I

   The difference between the present value of future cash flows and the initial investment outlay.

   Apply the discount factor derived from the tables to the cash flows. Use the given interest rate (required rate of return, discount rate, cost of capital) with either Exhibit and the appropriate cash flows.

   1. Use the information in (a) to calculate NPV.

   2. Use the information in (b) to calculate NPV. Then adjust the amounts and recalculate NPV.

   3. Use the information in (c) to calculate the initial investment. I = P - NPV

   Review the "How to Assess Cash Flows and Calculate Net Present Value" example in the text.

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Answer 1

1	ARR=Average net income/Initial investment
	Average net income:
				$	$
	Cash revenues				6000000
	Less:
	Cash expenses			4800000
	Depreciation expense
	(3700000-0)/5			740000	5540000
	Average net income				460000
	ARR=460000/3700000=0.1243=12.43%
2	ARR=Average net income/Initial investment
	Average net income=Total net income/Life of the project
	Depreciation expense=75000/5=$ 15000
	Project A:
	Average net income:
	Year	Cash revenues minus cash expenses	Depreciation expense	Net income
		a	b	c=a-b
	1	22500	15000	7500
	2	30000	15000	15000
	3	45000	15000	30000
	4	75000	15000	60000
	5	75000	15000	60000
	Total net income			172500
	Life of the project			5
	Average net income			34500
	ARR=Average net income/Initial investment=34500/75000=0.46=46%
	Project B:
	Average net income:
	Year	Cash revenues minus cash expenses	Depreciation expense	Net income
		a	b	c=a-b
	1	22500	15000	7500
	2	30000	15000	15000
	3	45000	15000	30000
	4	22500	15000	7500
	5	22500	15000	7500
	Total net income			67500
	Life of the project			5
	Average net income			13500
	ARR=Average net income/Initial investment=13500/75000=0.18=18%
	ARR shows the net income generated from the project.
	Project with a higher ARR is preferred.
	Hence, Project A should be preferred
3	ARR=Average net income/Initial investment
	Initial investment=Average net income/ARR=220000/30%=$ 733333
4	ARR=Average net income/Initial investment
	Average net income=Initial investment*ARR=200000*50%=$ 100000