Q2TI - Horngren'S Financial And Managerial Accounting

Question

Lockwood Company is considering a capital investment in machinery:

Initial investment $ 600,000

Residual value 50,000

Expected annual net cash inflows 100,000

Expected useful life 8 years

Required rate of return 12%

8. Calculate the payback.

9. Calculate the ARR. Round the percentage to two decimal places.

10. Based on your answers to the above questions, should Lockwood invest in the machinery?

Step-by-Step Solution

Answer

8. The payback of the company is 6 Years.

9. Average annual operating income of the company is 9.62%.

10. No, the company should not invest in the machinery.

Step 1: 8. Comouting payback-

$\begin{array}{c}\text{Payback}=\frac{\text{Amount invested}}{\text{Expected annual net cash inflow}}\\ =\frac{\$600,000}{\$100,000}\\ =6\text{years}\end{array}$

Step 2: Calculating Average Annual Operating Income-

Total net cash inflows during operating life of the asset (a*8)	$800,000
Less: Total depreciation during operating life of the asset (Cost − Residual Value) (b)	$550,000
Total operating income during operating life (c= a-b)	$250,000
Divide by: Asset’s operating life in years (d)	8
Average annual operating income from asset (c/d)	$31,250

Step 3: Calculating Average amount invested-

$\begin{array}{c}\text{Average amount invested}=\frac{\left(\text{Amount invested}+\text{ Residual value}\right)}{2}\\ =\frac{\left(\$600,000+\$50,000\right)}{2}\\ =\frac{\$650,000}{2}\\ =\$325,000\end{array}$

Step 4: 9. Computing ARR-

$\begin{array}{c}\text{ARR}=\frac{\text{Average annual operating income}}{\text{Average amount invested}}\\ =\frac{\$31,250}{\$325,000}\\ =0.0962\text{ or }9.62\%\end{array}$

Step 5: 10. Investment analysis-

The required rate of return estimated by the company is 12% and the company should not approve an investment if it is less than estimated percentage. The computed percentage is 9.62% that is lower than the estimated percentage and thus the company should not proceed with investment.