Question

Toyland Products is considering producing toy action figures and sandbox toys. The products require different specialized machines, each $1 million. Each machine has a five-year year life and zero residual value. The two products have different patterns of predicted net cash inflows.

	Annual Net Cash Inflows
Year	Toy action	Sandbox toy
	figure project	project
1. . . . . . . . . . . . . . .	$317,750	$510,000
2. . . . . . . . . . . . . . .	317,750	360,000
3. . . . . . . . . . . . . . .	317,750	300,000
4. . . . . . . . . . . . . . .	317,750	280,000
5. . . . . . . . . . . . . . .	317,750	30,000
Total	$1,588,750	$1,480,000

Toyland will consider making capital investments only if the payback period of the project is less than 3.5 years and the ARR exceeds​ 8%.

Calculate the toy action figure​ project's ARR. If the toy action figure project had a residual value of $125,000​, would the ARR​ change? Explain and recalculate if necessary. Does this investment pass Toyland​'s ARR screening​ rule?

Answer 1

Solution :

ARR for toy action project = Average annual operating income / Initial investment

Annual depreciation = $1,000,000 / 5 = $200,000

Annual operating income = Annual cash inflows - Depreciation = $317,750 - $200,000= $117,750

ARR = $117,750 / $1,000,000 = 11.78%

If the toy action figure project had a $125,000 residual value, the ARR would change.

The residual value would cause the yearly depreciation expense to decrease which will cause the annual operating income from investment to increase.

Annual depreciation expense = ($1,000,000 - $125,000) / 5 = $175,000

Annual operating income = $317,750 - $175,000 = $142,750

ARR of toy action figure project if residual value is $125,000 = $142,750 / $1,000,000 = 14.28%

The ARR in both case exceeds toy minimum required ARR, therefore toy action figure passes through the company's screening rule in both cases.