Project Analysis – Capital Budgeting Techniques

 

Nile’s Manufacturing is considering buying automated machinery that costs $250,000. Working capital requirement is $25,000 and they are expecting Annual cash savings of $103,000 for 5 years. The company uses straight-line depreciation method. The salvage value the machinery at the end of year 5 is expected to be $10,000. The working capital will be recovered at the end of the machine’s life.

Calculate the accounting rate of return based on the initial investment. Should the company invest in this project?

Cost of an automated machine= $250,000
Working Capital requirements= $25,000
Salvage value= $4,000
Recovery of Working Capital= $4,000  (at the end of of the machine’s life)
Annual Cash savings= $10,000

Solution:

First, we will calculate the net cash flows for the given project.

 

ARR=Average Annual Net Income/Initial Investment outlay

Annual net operating profit= $60,000

ARR= 21.8%

If Company’s cost of capital is less than 21.8% then company should invest in the project.