Question

Refer to the Hunter Valley Snow Park Lodge expansion project in Short Exercise S26-4 and your calculations in Short Exercises S26-5 and S26-6. Assume the expansion has zero residual value.

Requirements

1. Will the payback change? Explain your answer. Recalculate the payback if it changes. Round to one decimal place.

2. Will the project’s ARR change? Explain your answer. Recalculate ARR if it changes. Round to two decimal places.

3. Assume Hunter Valley screens its potential capital investments using the following decision criteria:

Maximum payback period	5.0 years
Maximum accounting rate of return	18.00%

Short answer

(1) Payback period remains unaffected

(2) Accounting rate of return decreases;.

(3)The business entity must consider this project further, even if the residual value is $0.

Step-by-step solution

Definition of Capital Budgeting

The process of evaluating various available investments is known as capital budgeting. This process compares the benchmarks with the expected return from the investment.

Change in payback

The payback period will not change due to a change in the residual value because, in the calculation of the payback period, expected annual cash flow is considered, which is not adjusted with the depreciation expenses. The change in residual value will affect the depreciation expenses and will not affect the expected annual cash flow. The payback period will remain the same, i.e., 4.1 years.

Change in ARR

The accounting rate of return will decrease when the residual value becomes $0. The calculation is shown below:

$\begin{array}{c}\mathrm{ARR}=\frac{\mathrm{Average}\mathrm{annual}\mathrm{operating}\mathrm{income}}{\mathrm{Average}\mathrm{amount}\mathrm{invested}}\\ =\frac{\mathrm{\$}1,143,327.43}{\mathrm{\$}5,800,000}\\ =19.71\mathrm{\%}\end{array}$

Working note:

data-custom-editor="chemistry" $\begin{array}{c}\mathrm{Average}\mathrm{annual}\mathrm{net}\mathrm{cash}\mathrm{flow}=\left(\begin{array}{l}\mathrm{Number}\mathrm{of}\mathrm{additional}\mathrm{skiers}\times \mathrm{Averagenumber}\mathrm{of}\mathrm{days}\mathrm{allow}\mathrm{skiing}\times \\ \left(\mathrm{Average}\mathrm{cash}\mathrm{spent}\mathrm{by}\mathrm{skier}-\mathrm{Average}\mathrm{variable}\mathrm{cost}\mathrm{per}\mathrm{skier}\right)\end{array}\right)\\ =\left(121\times 142\left(\mathrm{\$}241-\mathrm{\$}83\right)\right)\\ =\mathrm{\$}2,714,756\end{array}$

$\begin{array}{c}\mathrm{Average}\mathrm{annual}\mathrm{operating}\mathrm{income}=\mathrm{Average}\mathrm{annual}\mathrm{net}\mathrm{cash}\mathrm{inflow}-\mathrm{Depreciation}\\ =\mathrm{\$}2,714,756-\mathrm{\$}1,571,428.57\\ =\mathrm{\$}1,143,327.43\end{array}$

Calculation-Calculation of depreciation on a straight-line method.

$\begin{array}{c}\mathrm{Depreciation}=\frac{\mathrm{Cost}-\mathrm{Residual}\mathrm{value}}{}\\ =\frac{\mathrm{\$}11,000,000-\mathrm{\$}0}{}\\ =\mathrm{\$}1,571,428.57\end{array}$

$\begin{array}{c}\mathrm{Average}\mathrm{amount}\mathrm{invested}=\frac{\mathrm{Amount}\mathrm{invested}+\mathrm{Residual}\mathrm{value}}{}\\ =\frac{\mathrm{\$}11,000,000+\mathrm{\$}600,000}{}\\ =\mathrm{\$}5,800,000\end{array}$

Analysis of potential investment

Hunter valley will consider this project further because both the project evaluation parameters reflect a good position. The payback period is less than the maximum payback period, and the accounting rate of return is higher than the maximum accounting rate of return.