Accounting Rate of Return Each of the following scenarios is independent. Assume
ID: 2720590 • Letter: A
Question
Accounting Rate of Return
Each of the following scenarios is independent. Assume that all cash flows are after-tax cash flows.
Cobre Company is considering the purchase of new equipment that will speed up the process for extracting copper. The equipment will cost $3,600,000 and have a life of 5 years with no expected salvage value. The expected cash flows associated with the project are as follows:
Emily Hansen is considering investing in one of the following two projects. Either project will require an investment of $75,000. The expected cash revenues minus cash expenses for the two projects follow. Assume each project is depreciable.
Suppose that a project has an ARR of 30% (based on initial investment) and that the average net income of the project is $120,000.
Suppose that a project has an ARR of 50% and that the investment is $150,000.
Required:
1. Compute the ARR on the new equipment that Cobre Company is considering. Round your answer to one decimal place.
%
2. Conceptual Connection: Which project should Emily Hansen choose based on the ARR? Notice that the payback period is the same for both investments (thus equally preferred). Unlike the payback period, explain why ARR correctly signals that one project should be preferred over the other.
Based on the ARR, Emily Hansen choosen .
3. How much did the company in Scenario c invest in the project?
$
4. What is the average net income earned by the project in Scenario d?
$
Explanation / Answer
1. CALCULATION OF ARR ON THE NEW EQUIPMENT
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YEAR 1 2 3 4 5
Cash Revenue 6,000,000 6,000,000 6,000,000 6,000,000 6,000,000
(-) Cash Expenses 4,800,000 4,800,000 4,800,000 4,800,000 4,800,000
Profit 1,200,000 1,200,000 1,200,000 1,200,000 1,200,000
(-) Depreciaiton 720,000 720,000 720,000 720,000 720,000
Profit After Depreciation 480,000 480,000 480,000 480,000 480,000
Average Profit = $ 480,000; Initial Investment = $ 3,600,000
ACCOUNTING RATE OF RETURN = (AVERAGE PROFIT /INITIAL INVESTMENT) X 100
= (480,000/3,600,000) X 100 = 13.33%
NOTE; DEPRECIAITON = COST OF EQUIPMENT/LIFE = 3,600,000/5 = 720,000
2. CALCULATION OF ACCOUNTING RATE OF RETURN - PROJECT A:
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YEARS 1 2 3 4 5
INCOME BEFORE DEP. 22,500 30,000 45,000 75,000 75,000
(-) DEPRECIATION 15,000 15,000 15,000 15,000 15,000
INCOME AFTER DEP. 7,500 15,000 30,000 60,000 60,000
AVERAGE INCOEM = 7,500+15,000+30,000+60,000+60,000/5= 172,500/5 = 34,500
INITIAL INVESTMENT = 75,000
ACCOUNTING RATE OF RETURN = (AVERAGE INCOME/INITIAL INVESTMENT) X 100
= (34,500/75,000) X100 = 46%
NOTE: DEPRECIATION = 75,000/5 = 15,000
CALCULATION OF ARR FOR PROJECT B
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YEARS 1 2 3 4 5
INCOME BEFORE DEP. 22,500 30,000 45,000 22,500 22,500
(-) DEPRECIAITON 15,000 15,000 15,000 15,000 15,000
INCOME 7,500 15,000 30,000 7,500 7,500
AVERAGE INCOME = 7,500+ 15,000+30,000+7,500 + 7,500/5 = 67,500/5 =13,500
INITIAL INVESTMENT = 75,000
ARR = (AVERAGE INCOME/INITIAL INVESTMENT) X 100 = (13,500/75,000) X100 = 18%
DECISION = SINCE ARR OF PROJECT A IS MORE THAN PROJECT B, PROJECT A SHOULD BE CHOOSEN.
NOTE: DEPRECIATION = 75,000/5 = 15,000
3. ARR = AVERAGE INCOME/INITIAL INVESTMENT; SO INITIAL INVESTMENT = AVERAGE INCOME/ARR = 120,000/0.30 = $400,000
4. CALCULATION OF AVERAGE NET INCOME = ARR = AVERAGE INCOME/INITIAL INVESTMENT; AVERAGE INCOME= INITIAL INVESTMENT X ARR = 150,000 X 50% = 75,000