Accounting rate of return, payback, and NPV
Busy Beaver Corp. is interested in reviewing its methods of evaluating capital expenditure proposals using the accounting rate of return method. A recent proposal involved a $50,000 investment in a machine that had 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 payback period of three years or less.
A) 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.
B) Calculate the payback period for this investment. Based on this analysis, would the investment be made ? Explain your answer.
C) Calculate the net present value of this investment using a cost of capital of 16%. Based on this analysis ,would the investment be made? Explain your answer.
D) What recommendation would you make to the management of Busy Beaver Corp. about evaluating capital expenditure proposals? Support your recommendation with the appropriate rationale.
Solution helps in explaining and computing the depreciation, accounting rate of return, average investment, payback, and NPV.