Playtime Products is considering producing toy action figures and sandbox toys.
ID: 2584514 • Letter: P
Question
Playtime 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 (Click the icon to view the data ) Calculate the toy action figure project's ARR. If the toy action figure project had a residual value of $200,000, would the ARR change? Explain and recalculate if necessary Does this investment pass Playtime's ARR screening rule? First, enter the formula, then compute the ARR of the toy action figure project (Enter amounts in dollars, not millions. Enter your answer as a percent rounded to two decimal places) Accounting rate of returnExplanation / Answer
Step 1 Calculation of ARR of toy action figure if residual value is zero
ARR of toy action figure project = (Average Annual Profit/Initial Investment)*100
Annual Profit = (Net cash inflow - Annual Depreciation)
Annual Depreciation = (Cost - Residual value)/useful life = ($1,000,000-0)/5 yrs = $200,000
Annual Profit = $428,750-$200,000 = $228,750
Average Annual Profit = Total profit for 5 years/Useful life = ($228,750*5)/5 yrs = $228,750
Initial Investment = $1,000,000
ARR of toy figure project = ($228,750/1,000,000)*100 = 22.88%
Step 2 Calculation of ARR of toy action figure if residual value is $200,000
If residual value is $200,000, then annual depreciation = ($1,000,000-$200,000)/5 yrs = $160,000
Thus due to change in annual depreciation the average annual profit will also change and ARR also change which is calculated as follows:-
Average Annual Profit = Cash inflows-Depreciation = $428,750-$160,000 = $268,750
ARR = (Average Annual Profit/Initial Investment)*100 = ($268,750/1,000,000)*100 = 26.88%
Step 3 Passing of Playtime's ARR screening rule
Playtime will consider making capital investments only if the payback period of the project is less than 3.5 years and the ARR exceeds 8%. The ARR in both the above steps is greater than 8% (i.e.22.88% and 26.88%). Thus this investments pass the ARR screening rule of Playtime.
The Payback period of this investment = Initial Investment/net Annual cash inflows
= $1,000,000/$428,750 = 2.33 years.
The capital project's Payback period is also less than 3.5 years (i.e.2.33 yrs). Thus this project also passes the Playtime's Payback period screening rule.