Cardinal Company is considering a project that would require a $2,975,000 invest

Question

Cardinal Company is considering a project that would require a $2,975,000 investment in equipment with a useful life of five years. At the end of five years, the project would terminate and the equipment would be sold for its salvage value of $300,000. The company's discount rate is 14%. The project would provide net operating income each year as follows: Sales Variable expenses $2,735,000 1,000,000 1,735,000 Contribution margin Fixed expenses: Advertising, salaries, and other fixed out-of-pocket costs Depreciation $735,000 535,000 Total fixed expenses 1,270,000 Net operating income $ 465,000

Explanation / Answer

calculating payback period using undiscounted cash flows:

Payback period = (Initial Investment - Salvage Value) / Annual cash inflows

Computation annual cashinflows = Net Operating income + non-cash expenses (Depreciation)

= 4,65,000+5,35,000 = 1,000,000

Initial Investment = (2,975,000 - 3,00,000) = 2675000

By applying the Payback Period formula = 2675000/1000000 =2.68 Years

Project's Simple Rate of Return = (Profit after depreciation /Initial Investment)*100

   = (465000/ 2675000) *100 = 17.38%

What if salvage value is changed,

Depreciation = (Cost of the machine - salvage value) / Number of years

= (2975000 - 500000)/5 = 495000

The new depreciation is 495000 .. we should add the new depreciation instead of old depreciation 535000

Total fixed expenses = 735000+495000 = 1230000

Therefore contribution margin - total fixed expenses = new operating income = 505000

Initial investment if salvage value becomes 5,00,000 = cost of the machine - salvage value

= 2975000 -500000 = 2475000

Simple rate of return = (505000/2475000)*100 =20.40

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