Question

1. Accounting Rate of Return

   Each of the following scenarios is independent. Assume that all cash flows are after-tax cash flows.

   1. Cobre Company is considering the purchase of new equipment that will speed up the process for extracting copper. The equipment will cost $3,800,000 and have a life of 5 years with no expected salvage value. The expected cash flows associated with the project are as follows:

      Year		Cash Revenues		Cash Expenses
      1		$6,000,000		$4,800,000
      2		6,000,000		4,800,000
      3		6,000,000		4,800,000
      4		6,000,000		4,800,000
      5		6,000,000		4,800,000

   2. 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.

      Year		Project A		Project B
      1		$22,500		$22,500
      2		30,000		30,000
      3		45,000		45,000
      4		75,000		22,500
      5		75,000		22,500

   3. Suppose that a project has an ARR of 30% (based on initial investment) and that the average net income of the project is $170,000.
   4. Suppose that a project has an ARR of 50% and that the investment is $225,000.

   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.

   	ARR
   Project A	%
   Project B	%

   Based on the ARR, Emily Hansen chosen Project A .

   3. How much did the company in Scenario c invest in the project? Round your answer to the nearest whole dollar.
   $

   4. What is the average net income earned by the project in Scenario d?
   $

Check My Work

Answer 1

1. Average Rate of Return ( ARR) : Average net profit/ Average Investment

Average net profit: Total profits over investment period/ No. of years

Average Investment ( when no salvage value): Total investment/2

Average net profit:

As cash income and cash expense are same in all 5 yeras we will do calculation by deduction of cash expense and depreciation together.

Depreciation: Investment/ no. of years :

: 38,00,000/5: $ 7,60,000

Average net profit: $ 60,00,000- $ 48,00000-$ 7,60,000

: $ 4,40,000

Average Investment: $ 38,00,000/2 : $ 19,00,000

ARR: $ 4,40,000/$ 19,00,000 : 23.16%

2.ARR Of project A :

Average net profit: (Total income/no of years) - Depreciation

($ 22,500+$ 30,000+ $ 45,000+$ 75,000+ $ 75,000)/5 - ($75,000/5) =$34,500

Average Investment: $ 75,000/ 2: $ 37,500

ARR: $34,500/$ 37,500 = 92%

Project B :

Average net profit :( total income/ no of years)- depreciation

: ($ 22,500+$30,000+$45,000+$22,500+$22,500/5) - ($75,000/5)

:$13,500

Average Investment: $ 75000/2 : $37,500

ARR : $ 13,500/$37,500: 36%

ARR is perferred when same pay back period because it suggests the average return one project can earn over a period of time , in case same pay back period which means that investment can be earned back within same period return over the period gets preference .

Thus project A has correctly selected

3. Average Investment : Average net profit /ARR

$ 1,70,000/30%: $ 5,66,667

Intial investment ( when no salvage value) : Average Investment*2 : $ 5,66,667*2 :$ 11,33,333( rounding up).

4. Average net income: ARR* Average Investment

: 50%* $ 2,25,000

: $. 1,12,500