Kenneth Gould is the general manager at a small-town newspaper that is part of a national media chain. He is seeking approval from corporate headquarters (HQ) to spend $20,000 to buy some Macintosh computers and a laser printer to use in designing the layout of his daily paper. This equipment will be depreciated using the straight-line method over four years.
These computers will replace outmoded equipment that will be kept on hand for emergency use. HQ requires Kenneth to estimate the cash flows associated with the purchase of new equipment over a four-year horizon. The impact of the project on net income is derived by subtracting depreciation from cash flow each year.
The project's average accounting rate of return equals the average contribution to net income divided by the average book value of the investment. HQ accepts any project that (1) has an average accounting rate of return that exceeds the cost of capital of 15 percent, and (2) returns the initial investment within four years (on a cash flow basis).
The following are Kenneth's estimates of cash flows:
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Year 1
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Year 2
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Year 3
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Year 4
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Cost Savings
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$ 7,500
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$ 9,100
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$ 9,100
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$ 9,100
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a. What is the average contribution to net income across all four years?
b. What is the average book value of the investment?
c. What is the average accounting rate of return?
d. What is the payback period of this investment?
e. Critique the company's method for evaluating investment proposals.