Accounting Rate of Return Each of the following scenarios is independent. Assume

Question

Accounting Rate of Return

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

Cobre Company is considering the purchase of new equipment that will speed up the process for extracting copper. The equipment will cost $3,600,000 and have a life of 5 years with no expected salvage value. The expected cash flows associated with the project are as follows:

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.

Suppose that a project has an ARR of 30% (based on initial investment) and that the average net income of the project is $120,000.

Suppose that a project has an ARR of 50% and that the investment is $150,000.

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.

Based on the ARR, Emily Hansen choosen Project A .

3. How much did the company in Scenario c invest in the project?
$

4. What is the average net income earned by the project in Scenario d?
$

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

Explanation / Answer

Answer 1. ARR = Average Operating Income / Average Investment Average Operating Income = 6,000,000 (Cash revenues) - 4,800,000 (Cash expenses) - 720,000 (Dep.) = $480,000 Assuming depreciation is charged on Straight Line Method Average Investment = (3,600,000 - 0) /2 = $1,800,000 ARR = 480,000 / 1,800,000 = 26.7% (Approx) Answer 2. Calculation of Avg. Operating income Year Project A Project B Net Cash Flow Dep Operating Income Net Cash Flow Dep Operating Income 1            22,500                15,000            7,500           22,500          15,000                7,500 2            30,000                15,000          15,000           30,000          15,000              15,000 3            45,000                15,000          30,000           45,000          15,000              30,000 4            75,000                15,000          60,000           22,500          15,000                7,500 5            75,000                15,000          60,000           22,500          15,000                7,500 Total        172,500              67,500 Avg Operating profit          34,500              13,500 Average Investment Project A = (75000 - 0) /2 = $37500 Project B = (75000 - 0) /2 = $37500 ARR = Average Operating Income / Average Investment Project A = 34500 / 37500 = 92% Project B = 13500 / 37500 = 36% As per ARR , Project A should be choosen. Payback period in capital budgeting refers to the period of time required to recoup the funds expended in an investment, or to reach the break-even point. Payback period doesn't take cash inflow after the break even point into the consideration. ARR takes Cash inflow of the total life of the assets, so ARR is better than Payback Period. Answer c. ARR = 30% = 120000 (Average Net Income) / Average Investment Average Investment = 400,000 Assuming no Salvage value in investment Investment = $800,000 (400,000 X 2) Answer d. ARR = Average Operating Income / Average Investment 50% = Average Income / 75000 (Average Investment) Average Income = $150,000

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