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Payback period, accounting rate of return, net present value

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Pleasant Company has an opportunity to invest in one of two new projects. Project Y requires a $700,000 investment for new machinery with a four- year life and no salvage value. Project Z requires a $700,000 investment for new machinery with a three- year life and no salvage value. The two projects yield the following predicted annual results. The company uses straight- line depreciation, and cash flows occur evenly throughout each year.

..........................................................................Project Y......Project Z
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $700,000..... $560,000
Expenses Direct materials . . . . . . . . . . . . . . . . . 98,000 .....70,000
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . 140,000..... 84,000
Overhead including depreciation . . . . . . . . . . 252,000 ......252,000
Selling and administrative expenses . . . . . . . . 50,000........ 50,000
Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 540,000...... 456,000
Pretax income . . . . . . . . . . . . . . . . . . . . . . . . . . . 160,000 .....104,000
Income taxes ( 30%) . . . . . . . . . . . . . . . . . . . . . . 48,000 ......31,200
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 112,000 .....$ 72,800

Required

1. Compute each project's annual expected net cash flows. (Round the net cash flows to the nearest dollar.)

2. Determine each project's payback period. (Round the payback period to two decimals.)

3. Compute each project's accounting rate of return. (Round the percentage return to one decimal.)

4. Determine each project's net present value using 8% as the discount rate. For part 4 only, assume that cash flows occur at each year- end. (Round the net present value to the nearest dollar.)

Analysis Component

5. Identify the project you would recommend to management and explain your choice.

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Solution Summary

This solution illustrates how to compute a project's payback period, accounting rate of return, and net present value.

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Net present value, payback, IRR, and accounting rate of return

Consider the following two mutually exclusive projects, each of which requires an initial investment of $100,000 and has no salvage value. The organization, which has a cost of capital of 15%, must choose one or the other (see attached)
Cash Inflows (End of year)
Year Project A Project B
1 $30,000 $0
2 $30,000 $20,000
3 $30,000 $20,000
4 $30,000 $50,000
5 $30,000 $90,000

a. compute the payback period of these projects. Using the payback criterion, which project is more desirable?
b. Compute the net present value of these two projects. Using the net present value criterion, which project is more desirable?

c. What do you think about the idea of using the payback period to adjust for risk?
d. How do you think about the idea of using the payback period to adjust for risk?
e. Compute the internal rate of return for each project
f. Assuming the straight-line depreciation is used to compute income, compute the accounting rate of return for these two projects

g. What do you think of the accounting rate of return criterion?

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