Question

Average Rate of Return—Cost Savings

Midwest Fabricators Inc. is considering an investment in equipment that will replace direct labor. The equipment has a cost of $85,000 with a $7,000 residual value and a ten-year life. The equipment will replace one employee who has an average wage of $18,370 per year. In addition, the equipment will have operating and energy costs of $4,130 per year.

Determine the average rate of return on the equipment, giving effect to straight-line depreciation on the investment. If required, round to the nearest whole percent.

Calculate Cash Flows

Nature’s Way Inc. is planning to invest in new manufacturing equipment to make a new garden tool. The new garden tool is expected to generate additional annual sales of 7,400 units at $46 each. The new manufacturing equipment will cost $144,300 and is expected to have a 10-year life and $11,100 residual value. Selling expenses related to the new product are expected to be 5% of sales revenue. The cost to manufacture the product includes the following on a per-unit basis:

Direct labor		$7.80
Direct materials		25.60
Fixed factory overhead-depreciation		1.80
Variable factory overhead		3.90
	Total	$39.10

Determine the net cash flows for the first year of the project, Years 2–9, and for the last year of the project. Use the minus sign to indicate cash outflows. Do not round your intermediate calculations but, if required, round your final answer to the nearest dollar.

Out of Eden, Inc.
Net Cash Flows
	Year 1	Years 2-9	Last Year
Initial investment	$
Operating cash flows:
Annual revenues	$	$	$
Selling expenses
Cost to manufacture
Net operating cash flows	$	$	$
Total for Year 1	$
Total for Years 2-9		$
Residual value
Total for last year			$

Answer 1

1
Annual cost savings	18370
Less: Operating and energy costs	4130
Less: Annual Depreciation	7800	=(85000-7000)/10
Annual net income	6440
Annual net income	6440
Divide by Average Investment	46000	=(85000+7000)/2
Average rate of return	14%

2

	Year 1	Years 2-9	Last year
Initial investment	-144300
Operating cash flows:
Annual revenues	340400	340400	340400
Selling expenses	-17020	-17020	-17020
Cost to manufacture	-276020	-276020	-276020
Net operating cash flows	47360	47360	47360
Total for year 1	-96940
Total for years 2-9		47360
Residual value			11100
Total for last year			58460
Workings:
Annual revenues	340400	=7400*46
Total manufacturing costs excluding depreciation	37.30	=39.10-1.80
Cost to manufacture	276020	=7400*37.30
Selling expenses	17020	=340400*5%