Unit 6 Written Assignment BUS 5110 – Managerial Accounting

By Peggy January
University of the People
MBA 2021-2022

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 
 $75,000 for equipment with useful life of 7 years and no salvage value. 

 Maintenance costs are expected to be $2,500 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 $10,000 per
year for the remaining years. 
 Labor is estimated to start at $50,000 in Year 1, increasing by 3% each year after. 

Revenues are estimated to be: 

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

-    50,000    113,000    125,000    125,000    150,000    150,000

Option 2 

 $50,000 for equipment with useful life of 7 years and a $10,000 salvage value 
 Maintenance costs are expected to be $4,500 per year and increase by 3% in Year 6
and remain at that rate. 
 Materials in Year 1 are estimated to be $25,000 but remain constant at $20,000 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 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

-    75,000    100,000    125,000    155,000    200,000    150,000

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.
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.

Some Theoretical Aspects:

According to Accounting Tools (2018), 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.).
Heisinger & Hoyle (n.d.) affirm 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 also state 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.
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.).
The payback period refers to the amount of time it takes to recover the cost of an investment.
Simply put, the payback period is the length of time an investment reaches a break-even point.
The desirability of an investment is directly related to its payback period. Shorter paybacks
mean more attractive investments.
The payback period is calculated by dividing the amount of the investment by the annual cash
flow.
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).

Data Analysis
Calculating the ARR: 1. Determine the average annual profit from the investment, which
could comprise of revenue less any annual costs of executing the investment. 2. Then, if the
investment is a fixed asset, deduct any depreciation cost from the annual revenue to arrive at
the average annual profit. 3. Afterwards divide the average annual profit by the initial cost of
the investment and multiply by 100 to get the percentage return (Murphy, 2020).
Option 1 NPV

Initial Investment $75,000

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

Revenue ($75.000) $50.000 $113.000 $125.000 $125.000 $150.000 $150.000

Maintenance Cost ($2500) ($2500) ($2500) ($2500) ($2500) ($2575) ($2575)

Material Cost ($20.000) ($10.000) ($10.000) ($10.000) ($10.000) ($10.000) ($10.000)

Labor Cost ($50.000) ($51.500) ($53.045) ($54.636) ($56.275) ($57.963) ($59.702)

Salvage value 0.00

Total cash flow ($75.000) ($72.500) ($14.000) $47.455 $57.864 $56.225 $79.462 $77.723

Rate return 8%

IRR 16%

NPV 1 $59.760

As seen in the table, NPV option 1 is > 0, which means the investment is acceptable and the
IRR is more than the required 8%, so option 1 is a good decision.

Option 2 NPV

Initial Investment $50,000

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

Revenue ($50.000) $75.000 $100.000 $125.000 $155.000 $200.000 $150.000

Maintenance Cost ($4500) ($4500) ($4500) ($4500) ($4500) ($4635) ($4635)

Material Cost ($25.000) ($20.000) ($20.000) ($20.000) ($20.000) ($20.000) ($20.000)

Labor Cost ($70.000) ($72.100) ($74.263) ($76.491) ($78.786) ($81.150) ($83.585)

Salvage value 10.000

Total cash flow ($50.000) ($99.500) ($21.600) $1.237 $24.009 $51.714 $94.215 $51.781

Rate return 8%

IRR 6%

NPV 2 ($17.236)

From the second table we can see that NPV for option 2 is < 0, which means the investment is
not acceptable and the investment is generating a return less tha the company required rate of
8%. So option 2 is not a good decision!
The payback method Option 1
Investment Cash Flow Unrecovered Invest. balance
Today 75.000
Year 1 (147.500)
Year 2 (161.500)
Year 3 (114.045)
Year 4 (56.181)
Year 5 43
Year 6 79.504
Year 7 157.227

The payback method Option 2

Investment Cash Flow Unrecovered Invest. balance

Today 50.000
Year 1 (149.500)
Year 2 (171.100)
Year 3 (169.863)
Year 4 (145.854)
Year 5 (94.140)
Year 6 76
Year 7 54.858

For option 1, the payback period is more than 6 years, while option 2 is more than 7 years,
which is more than the lifetime of the investment.
References
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 Staff. (15 April, 2021). The time value of money concept. Retrieved from
https://www.accountingtools.com/articles/the-time-value-of-money-concept.html

Accounting Tools Staff. (3 December, 2020). 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

Kagan, J. (16 March, 2021) Payback Period. Investopedia.com Retrieved from:

https://www.investopedia.com/terms/p/paybackperiod.asp

Murphy, C.B. (14 October, 2020). Accounting Rate of Return – ARR Definition. Retrieved
from https://www.investopedia.com/terms/a/arr.asp

Lumen Learning Staff. (n.d.). The relationship between risk and capital budgeting. Boundless
Finance. https://courses.lumenlearning.com/boundless-finance/chapter/the-relationship-
between-risk-and-capital-budgeting/