- Nova Industries purchased equipment for $720,000 that will save $95,000 annually in operating costs and generate $45,000 in additional annual revenue over 8 years. The equipment has a $80,000 salvage value and will be depreciated using straight-line method. What is the accounting rate of return using the average investment approach?
Answer: 15.0% based on net annual income of $60,000 and average investment of $400,000
Total annual benefits = $95,000 + $45,000 = $140,000. Annual depreciation = ($720,000 - $80,000) ÷ 8 = $80,000. Net annual income = $140,000 - $80,000 = $60,000. Average investment = ($720,000 + $80,000) ÷ 2 = $400,000. ARR = $60,000 ÷ $400,000 = 15.0%. Choice A uses cash flow instead of net income. Choice C uses initial investment instead of average. Choice D has calculation error in the income or investment figure.
- Arctic Ltd is comparing two investment alternatives. Project X requires $400,000 initially and generates cash flows of $95,000, $110,000, $125,000, $140,000, and $80,000 over five years. Project Y requires $450,000 initially and generates $130,000 annually for four years. If the company prioritizes shorter payback periods but requires minimum 20% accounting rate of return, which conclusion is most appropriate?
Answer: Select Project Y due to superior payback period of 3.46 years versus Project X's 3.68 years
Project X payback: $95K + $110K + $125K = $330K after 3 years. Need $70K more. $70K ÷ $140K = 0.5. Payback = 3.5 years. Project Y payback: $450K ÷ $130K = 3.46 years. Project Y has shorter payback, so if prioritizing payback, select Y. Choice A reverses the payback periods. Choices C and D require ARR calculations not fully provided in the scenario setup, making the payback comparison the primary decision factor.
- Using incremental analysis, what is the payback period for the replacement decision?
Answer: 6.0 years since the incremental cash flows of $150,000 annually exactly recover the investment
Incremental cash flows = $350,000 - $200,000 = $150,000 annually. Payback period = $900,000 ÷ $150,000 = 6.0 years. The salvage value is not considered in payback period calculation as it occurs at the end of the project life. Choice B incorrectly includes salvage value timing. Choice C uses net income instead of cash flows. Choice D uses total cash flows instead of incremental analysis.
- Meridian Corp is evaluating a new packaging machine with an initial cost of $240,000. The machine will generate annual net cash inflows of $45,000 for years 1-3, $60,000 for years 4-6, and $30,000 for years 7-8. Annual depreciation expense is $30,000. If the company requires a payback period of no more than 5.5 years, what can be concluded about this investment?
Answer: The project should be accepted since the payback period is 4.7 years
Payback period calculation: Years 1-3: $45,000 × 3 = $135,000 cumulative. Years 4-6: $60,000 × 1 = $60,000, bringing cumulative to $195,000 after 4 years. Remaining needed: $240,000 - $195,000 = $45,000. In year 5: $45,000 ÷ $60,000 = 0.75 years. Total payback = 4 + 0.75 = 4.75 years, which is less than 5.5 years, so accept. Choice A uses wrong calculation. Choice B incorrectly includes depreciation in cash flows. Choice D is wrong because payback can be calculated with uneven flows.
- Phoenix Industries has two mutually exclusive projects with identical $300,000 initial investments. Project Alpha has a 3.2-year payback period and generates $110,000 average annual accounting income. Project Beta has a 4.1-year payback period and generates $95,000 average annual accounting income. Both projects have 8-year useful lives with zero salvage values. Which project should be selected if both payback period and accounting rate of return are considered equally important?
Answer: Project Alpha because it has both superior payback period and higher accounting rate of return performance
Project Alpha: ARR = $110,000 ÷ $300,000 = 36.7%; Payback = 3.2 years. Project Beta: ARR = $95,000 ÷ $300,000 = 31.7%; Payback = 4.1 years. Alpha is superior on both measures (shorter payback and higher ARR). Choice B incorrectly interprets longer payback as positive. Choice C makes an unsupported assumption about capital rationing. Choice D ignores the performance differences shown by both metrics.
- Coastal Corp is analyzing an expansion project requiring $600,000 initial investment. The project will generate the following annual cash flows: Years 1-2: $120,000 each; Years 3-5: $180,000 each; Year 6: $100,000. Annual depreciation is $100,000, and additional working capital of $50,000 is required initially but recovered at project end. What is the project's payback period?
Answer: 3.61 years, calculated using total initial investment and operating cash flows only
Total initial investment = $600,000 + $50,000 = $650,000. Cumulative cash flows: Year 1: $120,000; Year 2: $240,000; Year 3: $420,000; Year 4: $600,000. After 3 years, need $650,000 - $420,000 = $230,000 more. In year 4: $230,000 ÷ $180,000 = 0.61 years. Payback = 3 + 0.61 = 3.61 years. Choice A ignores working capital in initial investment. Choice B incorrectly includes depreciation. Choice D confuses payback with NPV calculation method.
