Question

Sonoma is considering investing in solar paneling for the roof of its large distribution facility. The investment will cost $ 9 million and have a six?-year useful life and no residual value. Because of rising utility? costs, the company expects the yearly utility savings to increase over? time, as? follows: Year 1 . . . . . . . . . . . . . . . $1,000,000 Year 2 . . . . . . . . . . . . . . . $1,500,000 Year 3 . . . . . . . . . . . . . . . $2,000,000 Year 4 . . . . . . . . . . . . . . . $2,500,000 Year 5 . . . . . . . . . . . . . . . $3,500,000 Year 6 . . . . . . . . . . . . . . . $4,500,000 The company uses the payback period and ARR to screen potential investments. Company policy requires a payback period of less than five years and an ARR of at least 10?%. Any potential investments that do not meet these criteria will be removed from further consideration. 1. Calculate the payback period of the solar panels. 2. Calculate the ARR of the solar panels. 3. Should Sonoma turn down the solar panel investment or consider it? further?

Answer 1

Solution : (1.) calculation of payback period

Year	Saving	Accumulative saving
1	$1,000,000	$1,000,000
2	$1,500,000	$2,500,000
3	$2,000,000	$4,000,000
4	$2,500,000	$6,500,000
5	$3,500,000	$10,000,000
6	$4,500,000	$14,500,000

payback period = 4year + (1 year x $250,000 ÷ $350,000)

= 4 year + 0.714 year = 4 year and 8.5 months

(2.)

The formula for ARR is:

ARR = average annual profit ÷ average investment

   = $2,416,667 ÷ $4,500,000

= 53.70%

working :

Average investment = (book value at year 1+ book value at end of useful life) ÷ 2

= ($9,000,000 + 0 ) ÷ 2

= $4,500,000

Average annual profit = total profit over investment period ÷ number of years

= $14,500,000 ÷ 6 years

= $2,416,667

(3.) Since, solar panel investment's payback period is less than 5 years and ARR is more than 10%.

Conclusion : Hence, Sonoma should consider it further.