Grimason organization is considering the purchase of a machine that cost $100,00

Question

Grimason organization is considering the purchase of a machine that cost $100,000. it calculates that the purchase would contribute $ 30,000 in before tax income to the company. the company pays tax at an average 35% rate. The machines estimated useful life is 10 years with salvage value of $20,000. The company depreciates all fixed assets using the straight line methode. The Grimason requires a rate of return of at least 12%.

1. what is the payback period? Note: just calculate regular payback period, not discounted.

2. what is the accounting rate of return based on the avarage investment?

Explanation / Answer

1.

Income before taxes = $30,000

Income after taxes = $30,000 * (1-0.35) = $19,500

Annual depreciation = (Cost of Machine - Salvage value)/ Useful life = ($100,000-$20,000)/10 = $8,000

Annual cash flow = Income after taxes + tax savings on depreciation = $19,500 + ($8,000*0.35) = $22,300

Payback period = Initial investment/Annual cash flows = $100,000/$22,300 = 4.48 years

2.

Accounting profit = (Net income before taxes – Depreciation) * (1-tax rate) = ($30,000 - $8,000) *0.65 = $14,300

Average investment = (Initial cost of machine + Salvage value)/2 = ($100,000 + $20,000)/2 = $60,000

Accounting rate of return = $14,300/$60,000 = 0.2383 = 23.83%

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