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 $104,000 with a $9,000 residual value and a five-year life. The equipment will replace one employee who has an average wage of $33,590 per year. In addition, the equipment will have operating and energy costs of $10,070 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.
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Answer 1

Solution:

The Average Rate of Return is calculated using the formula

= Average Annual Income / Average Investment

Notes :

1.Calculation of Annual Depreciation:                       

As per the Information given in the question we have

Initial Investment = $ 104,000   ; Residual Value = $ $ 9,000 ; Life of the equipment = 5 Years

Thus Annual Depreciation = ( Initial Investment - Residual Value ) / Life of the equipment

= ( $ 104,000 - $ 9,000 ) / 5 = $ 95,000 / 5 = $ 19,000

2.Calculation of Average Annual Income:       

The Average Annual Income is calculated as follows

= Annual Savings of wages from replacement of employee – Annual Operating and energy costs – Annual Depreciation

As per the Information given in the question and we have

Annual Savings of wages from replacement of employee = $ 33,590 ;

Annual Operating and energy costs = $ 10,070     ;    Annual Depreciation = $ 19,000

Thus Average Annual Income = $ 33,590 - $ 10,070 - $ 19,000 = $ 4,520

3.Calculation of Average Investment :

The Average Investment is calculated as follows :

Average Investment = ( Initial Investment + Residual value at end of Year 5 ) / 2

As per the information given in the question we have

Initial Investment = $ 104,000 ;    Residual Value = $ 9,000

Thus Average Investment = ( $ 104,000 + $ 9,000 ) / 2

= $ 113,000 / 2 = $ 56,500

Calculation of Average rate of return on the equipment :

Thus Average Rate of Return = Average Annual Income / Average Investment

= $ 4,520 / $ 56,500 = 0.0800

= 8.00 %

Thus the Average Rate of Return on the equipment = 8.00 %