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Company A is planning to invest in a machinery. The cost of the machinery is $800,000. The machinery has an expected useful life 5 years. At the end of the 5 years, the machinery can be sold for $200,000.The expected net cash flow arising from using the machinery is as follows: Year   Expected net cash flow ($'000) 1 1402 1553 1604 1705 185REQUIRED:(a) Calculate the ARRAnnual depreciation expense = $Answer 1 Question 1Average profit = $Answer 2 Question 1Average investment = $Answer 3 Question 1ARR =Answer 4 Question 1%(b) If Company A's required rate of return is 10%, should it proceed to invest in the machinery?Decision: Answer 5 Question 1

Question

Company A is planning to invest in a machinery. The cost of the machinery is 800,000.Themachineryhasanexpectedusefullife5years.Attheendofthe5years,themachinerycanbesoldfor800,000. The machinery has an expected useful life 5 years. At the end of the 5 years, the machinery can be sold for 200,000.The expected net cash flow arising from using the machinery is as follows: Year   Expected net cash flow (′000) 11402155316041705185REQUIRED:(a)CalculatetheARRAnnualdepreciationexpense='000) 1 1402 1553 1604 1705 185REQUIRED:(a) Calculate the ARRAnnual depreciation expense = Answer 1 Question 1Average profit = Answer2Question1Averageinvestment=Answer 2 Question 1Average investment = Answer 3 Question 1ARR =Answer 4 Question 1%(b) If Company A's required rate of return is 10%, should it proceed to invest in the machinery?Decision: Answer 5 Question 1

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Solution

(a) To calculate the ARR (Accounting Rate of Return), we first need to calculate the annual depreciation expense, average profit, and average investment.

  1. Annual Depreciation Expense: This is calculated by subtracting the salvage value from the initial cost and then dividing by the useful life of the machinery. = (800,000−800,000 - 200,000) / 5 = $120,000

  2. Average Profit: This is calculated by adding up the expected net cash flows for each year and then subtracting the total depreciation over the 5 years. = (140,000+140,000 + 155,000 + 160,000+160,000 + 170,000 + 185,000)−(185,000) - (120,000 * 5) = 810,000−810,000 - 600,000 = $210,000

  3. Average Investment: This is calculated by adding the initial cost of the machinery and the salvage value, then dividing by 2. = (800,000+800,000 + 200,000) / 2 = $500,000

  4. ARR: This is calculated by dividing the average profit by the average investment and then multiplying by 100 to get a percentage. = (210,000/210,000 / 500,000) * 100 = 42%

(b) If Company A's required rate of return is 10%, then it should proceed to invest in the machinery because the ARR of 42% is significantly higher than the required rate of return. Therefore, the decision is to proceed with the investment.

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