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BUS 5110- Managerial Accounting- Written Assignment Unit

6#2
managerial accounting (University of the People)

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BUS 5110: Managerial Accounting- Written Assignment Unit 6

NVP, IRR and Payback Period

Written Assignment Unit 6
Managerial Accounting
Term 4 2020
BUS 5110
University of the People
May 2020

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BUS 5110: Managerial Accounting- Written Assignment Unit 6

Written Assignment

Submit a written paper which is 3-4 pages in length (no more than 4-pages), exclusive of the

reference page. Your paper should be double spaced in Times New Roman (or its equivalent)

font which is no greater than 12 points in size. The paper should cite at least three sources in

APA format. One source can be your textbook.

Please describe the circumstances of the following case study and recommend a course of

action. Explain your approach to the problem, perform relevant calculations and analysis, and

formulate a recommendation. Ensure your work and recommendation are thoroughly

supported.

Case Study:

A manufacturing company is evaluating two options for new equipment to introduce a new

product to its suite of goods. The details for each option are provided below:

Option 1

Year Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

80,000 95,000 130,000 140,000 150,000 160,000

 $65,000 for equipment with useful life of 7 years and no salvage value.

Maintenance costs are expected to be $2,700 per year and increase by 3% in

Year 6 and remain at that rate.

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BUS 5110: Managerial Accounting- Written Assignment Unit 6

 Materials in Year 1 are estimated to be $15,000 but remain constant at $10,000 per

year for the remaining years.

 Labor is estimated to start at $70,000 in Year 1, increasing by 3% each year after.

Revenues are estimated to be:

Year Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

75,000 100,000 125,000 150,000 150,000 150,000

Option 2

 $85,000 for equipment with useful life of 7 years and a $13,000 salvage value

 Maintenance costs are expected to be $3,500 per year and increase by 3% in Year 6

and remain at that rate.

 Materials in Year 1 are estimated to be $20,000 but remain constant at $15,000 per

year for the remaining years.

 Labor is estimated to start at $60,000 in Year 1, increasing by 3% each year after.

 Revenues are estimated to be:

 The company’s required rate of return and cost of capital is 8%.

Management has turned to its finance and accounting department to perform analyses and

make a recommendation on which option to choose. They have requested that the three main

capital budgeting calculations be done: NPV, IRR, and Payback Period for each option.

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BUS 5110: Managerial Accounting- Written Assignment Unit 6

For this assignment, compute all required amounts and explain how the computations were

performed. Evaluate the results for each option and explain what the results mean. Based on

your analysis, recommend which option the company should pursue.

Superior papers will:

 Perform all calculations correctly.

 Articulate how the calculations were performed, including from where values used in

the calculations were obtained.

 Evaluate the results computed and explain the meaning of the results, including why

certain measurements are more accurate than others.

 Recommend which option to pursue, supported by well-thought-out rationale, and

considering any other factors that could impact the recommendation.

Be sure to use APA formatting in your paper. Purdue University’s Online Writing Lab

(OWL) is a free website that provides excellent information and resources for understanding

and using the APA format and style. The OWL website can be accessed

here:

https://owl.purdue.edu/owl/research_and_citation/apa_style/apa_style_introduction.html

This assignment will be assessed using the BUS 5110 Unit 6 Written Assignment rubric.

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BUS 5110: Managerial Accounting- Written Assignment Unit 6

Introduction

Heisinger & Hoyle (n.d.) state that the required rate of return or the hurdle rate is the

minimum profit an investor will accept for an investment that pays off for a certain level of

risk whereas the cost of capital is the weighted average costs related to debt and equity

utilized in financing long-term investments. They further add that the time value of money

concept states that cash obtained today has more value compared to cash obtained at a

particular instance in the future. According to Accounting Tools (2018), present value

computations inform us of the value of cash flows in the present time’s dollars. The Net

present value (NPV) method sums the present value of all cash inflows and deducts the

present value of all cash outflows associated with a long-term investment. Investments are

acceptable in cases where NPV is greater than or equal to zero, otherwise, the investment is

rejected (Heisinger & Hoyle, n.d.). For a series of cash flows, the Internal Rate of Return

(IRR) is the rate necessary to yield an NPV of zero. When the IRR is more than or is

equivalent to the firm’s required rate of return then the investment is acceptable and vice

versa (Heisinger & Hoyle, n.d.). The payback method estimates the time required to recover

an initial investment and is usually given in years (Heisinger & Hoyle, n.d.). Accounting Rate

of Return (ARR) refers to the percentage rate of return projected on investment as connected

to the initial investment cost. ARR is found by dividing the average income from an asset by

the company's initial investment to yield a ratio or return which is projected over the lifespan

of the asset or project (Murphy, 2020).

Computations and Data Analysis

Calculating the ARR: Determine the average annual profit from the investment, which

could comprise of revenue less any annual costs of executing the investment. Then, if the

investment is a fixed asset, deduct any depreciation cost from the annual revenue to arrive at

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BUS 5110: Managerial Accounting- Written Assignment Unit 6

the average annual profit. Third, divide the average annual profit by the initial cost of the

investment and multiply by 100 to get the percentage return (Murphy, 2020). Below is the

summary of results

Option 1 Option 2
NPV $ (11,482.56) $5,374.57
IRR 6% 9%
Payback Period 5.9834 years 5.906 years
ARR 26.28% 29.17%
Option 1

 $65,000 for equipment with useful life of 7 years and no salvage value.

 Maintenance costs are expected to be $2,700 per year and increase by 3% in Year 6

onwards

 Materials in Year 1 are estimated to be $15,000 but remain constant at $10,000 per

year for the remaining years.

 Labor is estimated to start at $70,000 in Year 1, increasing by 3% after every year

The table below estimates the revenues

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

- 75,000 100,000 125,000 150,000 150,000 150,000

Cash

Flows

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

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BUS 5110: Managerial Accounting- Written Assignment Unit 6

(65,000
Purchase Price ) - - - - - - -
Maintenance
Costs - (2,700) (2,700) (2,700) (2,700) (2,700) (2,781) (2,781)

(15,000 (10,000 (10,000 (10,000 (10,000 (10,000 (10,000

Materials - ) ) ) ) ) ) )

(70,000 (72,100 (74,263 (76,491 (78,786 (81,149 (83,584

Added Labor - ) ) ) ) ) ) )

Revenue - - 75,000 100,000 125,000 150,000 150,000 150,000

(65,000 (87,700
Net Cash Flows ) ) (9,800) 13,037 35,809 58,514 56,070 53,635

NPV IRR

(11,483) 6%

 This option has a negative NPV, indicating no return or profit.

ARR
 This option has an IRR lower than the

company's required rate of return,

Total Revenue 750,000
indicating the company should not
Total Expenses (630,434)
accept this option.
Depreciation
Payback Expense (65,000)
Total Profit 54,566
Avg Annual
Profit 7,795

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BUS 5110: Managerial Accounting- Written Assignment Unit 6

Year 0 (65,000)

Year 1 (152,700)

Year 2 (162,500)

Year 3 (149,463)

Year 4 (113,654)

Year 5 (55,140)

Year 6 930

Year 7 54,566

Note: Because there is no salvage value, depreciation = purchase price

 Option 1 has a payback period of >6 years without considering TVM.

 Option 1 has an ARR equal to the company's required rate of return without

considering TVM which indicates the project should be accepted (versus IRR).

Option 2

 $85,000 for equipment with useful life of 7 years and a $13,000 salvage value

 Maintenance costs are expected to be $3,500 per year and increase by 3% in Year 6

and remain at that rate.

 Materials in Year 1 are estimated to be $20,000 but remain constant at $15,000 per

year for the remaining years.

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BUS 5110: Managerial Accounting- Written Assignment Unit 6

 Labor is estimated to start at $60,000 in Year 1, increasing by 3% each year after.

Revenue estimated to be:

Year
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 7
95,00
- 80,000 0 130,000 140,000 150,000 160,000
Cash
Flows

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

(85,00
Purchase Price 0) - - - - - - 13,000
Maintenance
Costs - (3,500) (3,500) (3,500) (3,500) (3,500) (3,605) (3,605)

(20,00 (15,00 (15,00 (15,00 (15,00 (15,00 (15,00

Materials - 0) 0) 0) 0) 0) 0) 0)

(60,00 (61,80 (63,65 (65,56 (67,53 (69,55 (71,64

Added Labor - 0) 0) 4) 4) 1) 6) 3)

130,00 140,00 150,00 160,00

Revenue - - 80,000 95,000 0 0 0 0

Net Cash (85,00 (83,50

Flows 0) 0) (300) 12,846 45,936 53,969 61,839 82,752

NPV IRR

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BUS 5110: Managerial Accounting- Written Assignment Unit 6

5,375 9%

 Option 2 has a positive NPV, indicating return or profit will be made.

 Option 2 has an IRR higher than the company's required rate of return, indicating

the company should accept this option.

Payback ARR
Total

Year 0 (85,000) Revenue 755,000

Total

Year 1 (168,500) Expenses (594,458)

Depreciatio

Year 2 (168,800) n Expense (72,000)


Total

Year 3 (155,954) Profit 88,542

Avg

Year 4 (110,018) Annual Profit 12,649

ARR 26%

Year 5 (56,048)

Year 6 5,790

Year 7 88,542

Option 2 has a payback period of >6 years without considering TVM.

 Option 2 has an ARR greater than the company's required rate of return without

considering TVM.

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BUS 5110: Managerial Accounting- Written Assignment Unit 6

Discussion of Results

Option 2 produced a higher NPV than option 1 and because the NPV is greater than

zero for option 2, the investment will generate a return greater than the company’s required

rate of return of 8 percent. IRR considers the time value of money to evaluate investments

just like NPV. However, the IRR offers surplus information that aids companies assess long-

term investments. If the IRR is higher than or equivalent to the company’s required rate of

return the investment, then the investment is accepted, hence, option 2 with an IRR of 9% is

accepted instead of option 1. ARR is useful for calculating the annual percentage rate of

return of an investment. Option 2 has a higher ARR of 29.17% therefore is in a better

standing than option 2. ARR however, doesn't put into consideration the time value of money

and it does not consider into account the effect of cash flow timing. Option 2 has a lower

payback period of 5.906 years compared 5.983 years for option 1. This means that option 2 is

in a better standing. However, the payback method has some weaknesses including: It does

not put into consideration the time value of money, the cash inflows beyond the payback

period are not considered as part of the study and lastly, it is not a measure of profitability

therefore is not good for company’s at verge of bankruptcy. In this case both the NPV and

IRR methods can be used as they match the profitability of each investment by putting into

consideration the time value of money for all cash flows associated to the investment.

Conclusion and Recommendation

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BUS 5110: Managerial Accounting- Written Assignment Unit 6

It is recommended that the company goes for option 2 as all its values are in a better

standing than option one as seen from the results discussion section. The qualitative factors

that may outweigh the quantitative factors in making a decision include strategic importance

to the company, industry leader in innovation, social benefits and new product line on sales

of existing product lines

References

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BUS 5110: Managerial Accounting- Written Assignment Unit 6

Accounting Hub. (n.d.). Accounting. Boundless.com CC BY-SA 4.0. Retrieved from

http://oer.org/mods/en-boundless/www.boundless.com/accounting/index.html

Accounting Tools. (2018, April 27). The time value of money concept. Retrieved from

https://www.accountingtools.com/articles/the-time-value-of-money-concept.html

Accounting Tools. (2018, July 18). Present value. Retrieved from

https://www.accountingtools.com/articles/2017/5/14/present-value

Heisinger, K., & Hoyle, J. B. (n.d.). Accounting for Managers. Retrieved from

https://2012books.lardbucket.org/books/accounting-for-managers/index.html

Murphy, C.B. (2020, January 28). Accounting Rate of Return – ARR Definition. Retrieved

10, 2020, from https://www.investopedia.com/terms/a/arr.asp

Walther, L. M. & Skousen, C. J. (2018). Managerial and Cost Accounting. Retrieved from

https://my.uopeople.edu/pluginfile.php/616278/mod_resource/content/3/managerial-

and-cost-accounting-compressed.pdf

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