Question

Year Sandbox toy Toy action figure project project 336,700 $ 550,000 1 2 336,700 340,000 3 336,700 310,000 4. 336,700 275,000 336,700 40,000 5 $ 1,683,500 $ 1,515,000 Total Toy Universe willl consider making capital investments only if payback period of the project is less than 3.5 years and the ARR exceeds 8%

Toy Universe Products is considering producing toy action figures and sandbox toys. The products require different specialized​ machines, each costing ​$1 million. Each machine has a​ five-year life and zero residual value. The two products have different patterns of predicted net cash inflows.

1. Calculate the sandbox toy​ project's ARR.

2. If the sandbox toy project had a residual value of $150,000 would the ARR​ change? Explain and recalculate if necessary.

3. Does this investment pass Toy UniverseToy Universe​'s ARR screening​ rule?

Answer 1

1. Sandbox Toy Project's ARR is 10.30%. Calculation is as below:

Particulars	Toy Action Project	Sandbox Toy Project
Cost of Machine	1000000	1000000
No. of years of useful life	5	5
Salvage Value	0	0
Depreciation per year = (Cost of Machine - Salvage Value) / No. of years of useful life	200000	200000
Cash Inflow:
Year 1	336700	550000
Year 2	336700	340000
Year 3	336700	310000
Year 4	336700	275000
Year 5	336700	40000
Total Inflow	1683500	1515000
Net Profit (with no salvage value) = Total Inflow - (Cost of Machine - Salvage Value)	683500	515000
Average Annual Profit = Net Profit / No. of years of useful life	136700	103000
Accounting Rate of Return (ARR) = Average Annual Profit / Cost of Machine	13.67%	10.30%

2. If the Sandbox project has a residual / salvage value of $1,50,000, then the ARR would be 13.30%. This is because the net inflow will increase with the amount of Residual Value and hence the average annual profit will increase; thereby increasing the ARR. Calculation is as below:

Particulars	Toy Action Project	Sandbox Toy Project
Cost of Machine	10,00,000	10,00,000
No. of years of useful life	5	5
Salvage Value	-	1,50,000
Depreciation per year = (Cost of Machine - Salvage Value) / No. of years of useful life	2,00,000	1,70,000
Cash Inflow:
Year 1	3,36,700	5,50,000
Year 2	3,36,700	3,40,000
Year 3	3,36,700	3,10,000
Year 4	3,36,700	2,75,000
Year 5	3,36,700	40,000
Total Inflow	16,83,500	15,15,000
Net Profit (with np salvage value) = Total Inflow - (Cost of Machine - Salvage Value)	6,83,500	6,65,000
Average Annual Profit = Net Profit / No. of years of useful life	1,36,700	1,33,000
Accounting Rate of Return (ARR) = Average Annual Profit / Cost of Machine	13.67%	13.30%

3. For a project to pass the screening rule, it should have a payback period of less than 3.5 years and ARR of more than 8%. With these rules, both the project will pass the screening rule as the ARR for both the projects is more than 8% (with or without residual value) and payback period for both the projects is less than 3.5 years (calculation as below).

		Projected
Toy Action Figure Project		Year 1	Year 2	Year 3	Year 4	Year 5	Total
Yearly cash flow	$ (10,00,000)	$ 3,36,700	$ 3,36,700	$ 3,36,700	$ 3,36,700	$ 3,36,700
Cumulative Net Cash Flow		(6,63,300)	(3,26,600)	10,100	3,46,800	6,83,500
Whether positive cash flow		FALSE	FALSE	TRUE	TRUE	TRUE
Fraction for positive cash flow (Cumulative Net Cash Flow / Net Cash Flow)				0.03
Net time for Pay back period (1-fraction for positive cash flow)				0.97
Total Payback period		1.0	1.0	0.97	-	-	2.97

		Projected
Sandbox Toy Project		Year 1	Year 2	Year 3	Year 4	Year 5	Total
Yearly cash flow	$ (10,00,000)	$ 5,50,000	$ 3,40,000	$ 3,10,000	$ 2,75,000	$ 40,000
Cumulative Net Cash Flow		(4,50,000)	(1,10,000)	2,00,000	4,75,000	5,15,000
Whether positive cash flow		FALSE	FALSE	TRUE	TRUE	TRUE
Fraction for positive cash flow (Cumulative Net Cash Flow / Net Cash Flow)				0.65	-	-
Net time for Pay back period (1-fraction for positive cash flow)				0.35	-	-
Total Payback period		1.0	1.0	0.35			2.35