Question

Playtime Products is considering producing toy action figures and sandbox toys. The products require different specialized​ machines, each costing $1 million. Each machine has a​ five-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. . . . . . . . . . . . . . .	$343,000	$550,000
2. . . . . . . . . . . . . . .	343,000	360,000
3. . . . . . . . . . . . . . .	343,000	310,000
4. . . . . . . . . . . . . . .	343,000	230,000
5. . . . . . . . . . . . . . .	343,000	50,000
Total	$1,715,000	$1,500,000

Playtime 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 sandbox toy​ project's ARR. If the sandbox toy project had a residual value of $225,000, would the ARR​ change? Explain and recalculate if necessary. Does this investment pass Playtime's ARR screening​ rule?

Answer 1

Solution :

ARR for sandbox project = Average annual operating income / Initial investment

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

Average Annual operating income = Average Annual cash inflows - Depreciation = ($1,500,000/5) - $200,000= $100,000

ARR = $100,000 / $1,000,000 = 10%

If the Sandbox project had a $225,000 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 - $225,000) / 5 = $155,000

Annual operating income = $300,000 - $155,000 = $145,000

ARR of Sandbox project if residual value is $225,000 = $145,000 / $1,000,000 = 14.50%

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