Question

Lockwood Company is considering a capital investment in machinery:

Initial investment $ 600,000

Residual value 50,000

Expected annual net cash inflows 100,000

Expected useful life 8 years

Required rate of return 12%

8. Calculate the payback.

9. Calculate the ARR. Round the percentage to two decimal places.

10. Based on your answers to the above questions, should Lockwood invest in the machinery?

Short answer

8. The payback of the company is 6 Years.

9. Average annual operating income of the company is 9.62%.

10. No, the company should not invest in the machinery.

Step-by-step solution

8. Comouting payback-

$\begin{array}{c}\text{Payback}=\frac{\text{Amountinvested}}{\text{Expectedannualnetcashinflow}}\\ =\frac{\$600,000}{\$100,000}\\ =6\text{years}\end{array}$

Calculating Average Annual Operating Income-

Total net cash inflows during operating life of the asset (a*8)	$800,000
Less: Total depreciation during operating life of the asset (Cost − Residual Value) (b)	$550,000
Total operating income during operating life (c= a-b)	$250,000
Divide by: Asset’s operating life in years (d)	8
Average annual operating income from asset (c/d)	$31,250

Calculating Average amount invested-

$\begin{array}{c}\text{Averageamountinvested}=\frac{\left(\text{Amountinvested}+\text{Residualvalue}\right)}{2}\\ =\frac{\left(\$600,000+\$50,000\right)}{2}\\ =\frac{\$650,000}{2}\\ =\$325,000\end{array}$

9. Computing ARR-

$\begin{array}{c}\text{ARR}=\frac{\text{Averageannualoperatingincome}}{\text{Averageamountinvested}}\\ =\frac{\$31,250}{\$325,000}\\ =0.0962\text{or}9.62\%\end{array}$

10. Investment analysis-

The required rate of return estimated by the company is 12% and the company should not approve an investment if it is less than estimated percentage. The computed percentage is 9.62% that is lower than the estimated percentage and thus the company should not proceed with investment.