Question

Acme Company is considering replacing outdated production equipment that will allow for production cost savings of $20,000 per month. The new equipment will have a five-year life and cost $800,000, with an estimated salvage value of $50,000. Acme's cost of capital is 10%. Required: Calculate the payback period and the accounting rate of return for the new production equipment. Assume straight-line depreciation. Note: Round your payback period answer to 2 decimal places and accounting rate of return answer to 1 decimal place. Payback period Accounting rate of return 3.33 years %

Answer 1

The payback period for the new production equipment is 40 months, and the accounting rate of return is 18.75%.

Step-by-step explanation:

The payback period is the amount of time it takes for an investment to recoup its initial cost. To calculate the payback period for the new production equipment, we need to determine how many months it will take to recover the initial investment. The new equipment costs $800,000 and the monthly savings is $20,000. So, the payback period can be calculated as:

Payback period = Initial investment / Monthly savings = $800,000 / $20,000 = 40 months

The accounting rate of return (ARR) is a measure of the profitability of an investment. It is calculated by dividing the average annual profit by the initial investment and expressing it as a percentage. ARR = Average annual profit / Initial investment * 100

First, we need to determine the average annual profit. The salvage value is subtracted from the initial investment to calculate the total depreciation. Total depreciation = Initial investment - Salvage value = $800,000 - $50,000 = $750,000

Next, we divide the total depreciation by the useful life of the equipment to get the annual depreciation. Annual depreciation = Total depreciation / Useful life = $750,000 / 5 years = $150,000

Finally, we divide the annual depreciation by the initial investment and multiply by 100 to get the accounting rate of return. ARR = Annual depreciation / Initial investment * 100 = $150,000 / $800,000 * 100 = 18.75% (rounded to 1 decimal place).