Question

OldSchool Corp. is reviewing its method of evaluating capital expenditure proposals using the accounting rate of return method. A recent proposal involved a $200,000 investment in a machine that had an estimated useful life of five years and an estimated salvage value of $20,000. The cash flow from the new machine was expected to increase net income before depreciation expense by $56,000 per year. OldSchool’s current policy for approving a new investment is that it have a rate of return of 12% and a payback period of three years or less.

(a) Calculate the accounting rate of return on this investment for the first year. Assume straight-line depreciation. Based on this analysis, would the investment be made? Explain.
(b) Calculate the payback period for this investment. Based on this analysis, would the investment be made? Explain.
(c) Comment on OldSchool’s current policy for capital expenditure proposals.

Answer 1

c) The current policy of old school seems bit strict and rigid. As company have well defined criteria to accept a project, it looks like both options won't fall into the companiy's criteria. And comany may not consider this project.