Crichton Publications uses the accounting rate of return met

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.)

Solution

Investment required = $330,000

Useful life = 4 years (since the salvage value will be received in fourth year)

Salvage value = $157,500

Depreciation using straight line method = 275,000 - 157,500 / 4 = $29,375

Accounting net income = $90,000 per year

1. ARR = (Average Net Income / Average Investment) * 100

Average Investment = 275,000 + 157,500 / 2 = $216,250

ARR = (90,000 / 216,250) * 100 = 41.61%

2. Since the ARR is more than the expected rate of return of 15%, so the investment should be made.

3. Calculation of NPV: