Question

B2B co. is considering the purchase of equipment that would allow the company to add a new product to its line. The equipment is expected to cost $120,000 with a 12-year life and no salvage value. It will be depreciated on a straight-line basis. The company expects to sell 48,000 units of the equipment's product each year. The expected annual income related to this equipment follows.
Sales $75,000
Costs Materials, labor, and overhead (except depreciation on new equipment) 40,000
Depreciation on new equipment 10,000
Selling and administrative expenses 7,500
Total costs and expenses 57,500
Pretax income 17,500
Income taxes (40%) 7,000
Net income $10,500

Required:
a. Compute the payback period.
b. Compute the accounting rate of return for this equipment.

Answer 1

Answer:

a. 5.85 years

b. 17.5%

Explanation:

a. For the computation of payback period first we need to find out the annual cash flow which is shown below:-

Annual Cash Inflow = Sales - Material - Selling and Administrative Expenses - Income Tax

= $75,000 - $40,000 - $7,500 - $7,000

= $20,500

Payback period = Initial investment ÷ Annual cash flow

= $120,000 ÷ $20,500

= 5.85 years

b. The computation of the accounting rate of return is shown below:-

accounting rate of return = Net income ÷ Average investment

= $10,500 ÷ ($120,000 ÷ 2)

= $10,500 ÷ $60,000

= 17.5%