Accounting: What the Numbers Mean 9th Edition by Wayne W McManus, Daniel F Viele, David H Marshall

Exercise 63

Accounting rate of return and NPV 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.

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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.

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

Step 1 of 5

Accounting rate of return and Net present value

Accounting rate of return : It refers to the ratio of average accounting profit of a particular project to its initial investment.

Net present value (NPV ): NPV is the distinction of present value between the cash inflows and cash outflows.