Question

You work in a manufacturing company which produces white goods. The company is planning an investment in a new product line.

The initial investment includes the machinery required for the production line which costs $320,000. Other expenses were included in the expected cash flows. The new machinery has a useful life of 4 years and an estimated residual value at the end of the 4^th year of $80,000. Depreciation is the only non-cash expense.

The net cash flows of each year in the following 4 years are estimated as follows:

Initial investment:               $320,000

Year 1:                                     10,000

Year 2:                                     80,000

Year 3:                                   140,000

Year 4:                                   120,000

Estimated sale of machinery: 80,000

The manager of the company asked you to evaluate the investment to make a decision whether the company would invest or not in this machinery. You evaluate the investment using the three investment decision methods you know.

The required rate of return of the company is 10% and the maximum payback period acceptable for the company is 3 years

1. What would be your recommendation based on the accounting rate of return (ARR) method? Calculate the ARR in percentage (round to 2 decimal places).                 

Average Profit =

Average investment =

ARR =

Recommendation? Why?

2. What would be your recommendation based on the payback period? Calculate the payback period in years (round to 2 decimal places).

Recommendation? Why?

3. What would be your recommendation based on the net present value method (NPV)? Use the table below to calculate NPV.

Decision? Why?

4. What is your final recommendation to the manager of the company? Why?                                                       

n	1%	2%	3%	4%	5%	6%	8%	10%	12%
1	0.990	0.980	0.971	0.962	0.952	0.943	0.926	0.909	0.893
2	0.980	0.961	0.943	0.925	0.907	0.890	0.857	0.826	0.797
3	0.971	0.942	0.915	0.889	0.864	0.840	0.794	0.751	0.712
4	0.961	0.924	0.888	0.855	0.823	0.792	0.735	0.683	0.636
5	0.951	0.906	0.863	0.822	0.784	0.747	0.681	0.621	0.567
6	0.942	0.888	0.837	0.790	0.746	0.705	0.630	0.564	0.507

Answer 1

Cost of assets		320000
Less: Salvage		80000
Depreciable cost		240000
Divide: Life		4
Annual depreciation		60000
Average Net Income
Year	Cashflows	Less: Dep	Net income
1	10000	-60000	-50000
2	80000	-60000	20000
3	140000	-60000	80000
4	120000	-60000	60000
Total Net income		110000
Divide: Years		4
Average Net Income		27500
Average Investment (320000+80000)/2 = 200,000
APR:
Average Net income		27500
Divide: Average investmetn	2,00,000
Accounting rate of return	13.75%
Payback period:
Year	Cashflows	Cumulative Cf
0	-320000	-320000
1	10000	-310000
2	80000	-230000
3	140000	-90000
4	200000	110000
Payback period = 3 years + 90000/200,000 = 3.45 years
NPV:
Year	Cashflows	PVF at 10%	Present value
1	10000	0.909091	9090.909
2	80000	0.826446	66115.7
3	140000	0.751315	105184.1
4	200000	0.683013	136602.7
Present value of inflows	316993
Less: Investment		-320000
NPV:			-3007
NOT recommended