# Accounting Rate of Return, Payback period, IRR

The directors of Makeit Ltd. Propose to buy a machine costing $300,000. At the end of 5 years the machine will be sold for $ 50,000. In each of the 5 years the machine will increase revenue by $160,000. Increased annual expenditure of $ 80,000 will be incurred. Makeit Ltd. will require an increase in working capital of $40,000. Machinery is depreciated on the straight line method."

Required

a) Calculate the accounting rate of return (ARR) which will result if the machine is purchased.

b) Calculate the discounted payback period for the machine. (Discount rate =10%)

c) i) Calculate the IRR

ii) State with reasons whether the directors should purchase the machine.

d) State the advantages and disadvantages of using the following methods:

1) ARR

ii) payback period

ii)IRR"

See attached for details.

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#### Solution Preview

See attached file

Step 1: Calculate the cash flow

Tax rate is not mentioned. We will assume tax to be zero.

Hence depreciation will not provide any tax shield.

The cash flow will be on account of purchase of machine, operations, sale of machine and working capital requirements

1) Cash flow from purchase and sale of machine:

Year investment in machine sale of machine

0 (300000)

1

2

3

4

5 50000

2) Cash flow from operations:

Increase in revenue= $160,000

Increase in expenses= $80,000

Net cash flow from operations= $80,000

Year Cash flow from operations:

0

1 80000

2 80000

3 80000

4 80000

5 80000

3) Cash flow from working capital requirements

Year Cash flow from working capital requirements

0 (40000) investment is made in working capital

1

2

3

4

5 40000 investment is recouped

Therefore total cash flow is:

Year investment in machine free cash flow from operations investment in working capital cash flow from sale of machine Total

0 (300,000) (40,000) (340,000)

1 80,000 80,000

2 80,000 80,000

3 80,000 80,000

4 80,000 80,000

5 80,000 40,000 50,000 170,000

a) Accounting ...

#### Solution Summary

Evaluates a capital budgeting decision (purchase of a machine) using Accounting Rate of Return, Payback period and Internal Rate of Return. Also lists the advantages and disadvantages of using Accounting Rate of Return, Payback period, Internal Rate of Return.

Compute the payback period. Is this a good measure of profitability?

2. Compute the NPV. Should Simon accept the proposal? Why or why not?

3. Compute the IRR. How does this compare with the required rate of return? Should Simon accept the proposal?

4. Using the accounting rate of return model, compute the rate of return on the initial investment.

Bob's Big Burgers is considering a proposal to invest in a speaker system that would allow its employees to service drive-through customers. The cost of the equipment (including installation of special windows and driveway modifications) is $30,000. Jenna Simon, manager of Bob's, expects the drive-through operation to increase annual sales by $25,000, with a 40% contribution margin ratio. Assume that the system has an economic life of six years, at which time it will have no disposal value. The required rate of return is 12%. Ignore taxes.

Required:

1. Compute the payback period. Is this a good measure of profitability?

2. Compute the NPV. Should Simon accept the proposal? Why or why not?

3. Compute the IRR. How does this compare with the required rate of return? Should Simon accept the proposal?

4. Using the accounting rate of return model, compute the rate of return on the initial investment.