Crichton Publications uses the accounting rate of return method to evaluate proposed capital investments. The companys desired

Question:

Crichton Publications uses the accounting rate of return method to evaluate proposed capital investments. The company’s desired rate of return (its cost of capital) is 18%. The project being evaluated involves a new product that will have a three-year life. The investment required is $300,000, which consists of a $240,000 machine, and inventories and accounts receivable totaling $60,000. The machine will have a useful life of three years and a salvage value of $150,000. The salvage value will be received during the fourth year, and the inventories and accounts receivable related to the product also will be converted back to cash in the fourth year. Accrual accounting net income from the product will be $87,000 per year, before depreciation expense, for each of the three years. Because of the time lag between selling the product and collecting the accounts receivable, cash flows from the product will be:

1st year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $42,000

2nd year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72,000

3rd year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87,000

4th year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000

Required:

a. Calculate the accounting rate of return for the first year of the product. Assume straight-line depreciation. Based on this analysis, would the investment be made? Explain your answer.

b. Calculate the net present value of the product using a cost of capital of 18% and assuming that cash flows occur at the end of the respective years. Based on this analysis, would the investment be made? Explain your answer.

c. Which of these two analytical approaches is the more appropriate to use? Explain your answer.

Net Present Value
What is NPV? The net present value is an important tool for capital budgeting decision to assess that an investment in a project is worthwhile or not? The net present value of a project is calculated before taking up the investment decision at... Salvage Value
Salvage value is the estimated book value of an asset after depreciation is complete, based on what a company expects to receive in exchange for the asset at the end of its useful life. As such, an asset’s estimated salvage value is an important... Accounts Receivable
Accounts receivables are debts owed to your company, usually from sales on credit. Accounts receivable is business asset, the sum of the money owed to you by customers who haven’t paid.The standard procedure in business-to-business sales is that... Cost Of Capital
Cost of capital refers to the opportunity cost of making a specific investment . Cost of capital (COC) is the rate of return that a firm must earn on its project investments to maintain its market value and attract funds. COC is the required rate of...