Question

Solomon Auto Repair, Inc. is evaluating a project to purchase equipment that will not only expand the company’s capacity but also improve the quality of its repair services. The board of directors requires all capital investments to meet or exceed the minimum requirement of a 10 percent rate of return. However, the board has not clearly defined the rate of return. The president and controller are pondering two different rates of return: unadjusted rate of return and internal rate of return. The equipment, which costs $105,000, has a life expectancy of six years. The increased net profit per year will be approximately $6,400, and the increased cash inflow per year will be approximately $22,713. (PV of $1 and PVA of $1) (Use appropriate factor(s) from the tables provided.)

    

Required

1. a-1. Determine the unadjusted rate of return and (use average investment) to evaluate this project. (Round your answer to 2 decimal places. (i.e., .2345 should be entered as 23.45).)

2. a-2. Based on the unadjusted rate of return, should the company invest in the equipment?

3. b-1. What is the approximate internal rate of return of this project?

4. b-2. Based on the internal rate of return, should the company invest in the equipment?

5. c. Which method is better for this capital investment decision?

a-1.	Unadjusted rate of return		%
a-2.	Should the company invest in the equipment?
b-1.	Internal rate of return		%
b-2.	Should the company invest in the equipment?
c.	Which method is better for this capital investment decision?

Answer 1

a1. Average investment = Cost / 2 = $105000 / 2 = $52500

Unadjusted rate of return = Net income / Average investment

Unadjusted rate of return = $6,400 / $52,500 = 12.19%

a2: The Company can invest in this project as the return of 12.19% is higher than 10%

b1: IRR = Initial investment / Annual cash inflows = $105,000 / $22713 = 4.6229

as per present value annuity table IRR = 8%

b2: As return of 10% is higher than IRR of 8%, the Company can invest in this project

c: IRR method is better for capital investment decision. as it calculates the minimum return required to reach break even of the project and it consider time value of money which unadjusted rate of return doesnot considers.