1) You’re trying to determine whether to expand your business by building a new
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Question
1) You’re trying to determine whether to expand your business by building a new manufacturing plant. The plant has an installation cost of $11.0 million, which will be depreciated straight-line to zero over its four-year life. If the plant has projected net income of $1,754,300, $1,807,600, $1,776,000, and $1,229,500 over these four years, what is the project’s average accounting return
Average accounting return %
2) Buy Coastal, Inc., imposes a payback cutoff of three years for its international investment projects.
What is the payback period for both projects? (Round your answers to 2 decimal places. (e.g., 32.16))
Which project should the company accept?
Year Cash Flow (A) Cash Flow (B) 0 –$ 57,000 –$ 67,000 1 21,500 13,500 2 25,000 16,500 3 19,500 23,000 4 6,500 227,000Explanation / Answer
1)
Average Accounting Return = [(Total net profit/No. of years)/Initial cost] x 100
Total net profit = $1,754,300 + $1,807,600 + $1,776,000 + $1,229,500 = $ 6,567,400
ARR = $ 6,567,400/4/$ 11,000,000 x 100
= $ 1,641,850/$ 11,000,000 x 100
= 0.149259091 x 100 = 14.93 %
2)
Project A
Year
Cash Flow
‘Cum Cash Flow
0
$ (57,000)
$ (57,000)
1
$ 21,500
$ (35,500)
2
$ 25,000
$ (10,500)
3
$ 19,500
$ 9,000
4
$ 6,500
$ 15,500
Payback period = A + B/C
Where,
A = Last period with a negative cumulative cash flow = 2 years
B = Absolute value of cumulative cash flow at the end of the period A = $ 10,500
C = Total cash flow during the period after = $ 19,500
Payback period = 2 + $ 10,500/$ 19,500 = 2 + 0.54 = 2.54
Project B
Year
Cash Flow
‘Cum Cash Flow
0
$ (67,000)
$ (67,000)
1
$ 13,500
$ (53,500)
2
$ 16,500
$ (37,000)
3
$ 23,000
$ (14,000)
4
$ 227,000
$ 213,000
Payback period = A + B/C
Where,
A = Last period with a negative cumulative cash flow = 3 years
B = Absolute value of cumulative cash flow at the end of the period A = $ 14,000
C = Total cash flow during the period after = $ 227,000
Payback period = 2 + $ 14,000/$ 227,000 = 3 + 0.06 = 3.06
Payback period
Project A
2.54
Project B
3.06
Company should accept project A based on Payback period.
Project A
Year
Cash Flow
‘Cum Cash Flow
0
$ (57,000)
$ (57,000)
1
$ 21,500
$ (35,500)
2
$ 25,000
$ (10,500)
3
$ 19,500
$ 9,000
4
$ 6,500
$ 15,500
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