Problem:
Accounting rate of return, payback, and NPV.
ABC Corp. is interested in reviewing its method of evaluating capital expenditure proposals using the accounting rate of return method. A recent proposal involved a $50,000 investment in a machine that an estimated useful life of five years and an estimated salvage value of $10,000. The machine was expected to increase net income (and cash flows) before depreciation expense by $15,000 per year. The criteria for approving a new investment are that it have a rate of return of 16% and a paycheck period of three years or less.
Required to do:
Q1. Calculate the accounting rate of return on this investment for the first year. Assume straight-line depreciation. Based on this analysis, would the investment be made? Explain your answer.
Q2. Calculate the payback period for this investment. Based on this analysis, would the investment be made? Explain the answer.
Q3. Calculate the net present value of this investment using a cost of capital of 16%. Based on the analysis, would the investment be made? Explain your answer.
Q4. What recommendation would you make to management of ABC Corp. about evaluating capital expenditure proposals? Support your recommendation with the appropriate rationale.