Question

Simply Chocolate Company is considering two possible expansion plans.Proposal X involves opening five stores in North Carolina at a cost of $2,400,000. Under Proposal Y, the company would focus on Virginia and open six stores at a cost of $3,000,000. The following information is given for the two proposals:

Proposal X Proposal Y

Required investment                                      $2,400,000        $3,000,000

Estimated life                                                   10 years              10 years

Estimated residual value                                  $200,000              $200,000

Estimated annual net cash flows                        $450,000             $580,000

Required rate of return                                       14%                      14%

Calculate the Accounting Rate of Return

Answer 1

Accounting Rate of Return (ARR) for Proposal-X

Straight line depreciation expense = [Cost of investment – Residual value] / Useful life

= [$2,400,000 - $200,000] / 10 Years

= $2,200,000 / 10 Years

= $220,000 per year

Annual net operating income = Annual net cash flow – Depreciation expenses

= $450,000 - $220,000

= $230,000

Average Investment = [Initial investment cost + Residual value] / 2

= [$2,400,000 + $200,000] / 2

= $2,600,000 / 2

= $1,300,000

Accounting Rate of Return (ARR) for Proposal-X = [Annual net operating income / Average investment] x 100

= [$230,000 / $1,300,000] x 100

= 17.69%

Accounting Rate of Return (ARR) for Proposal-Y

Straight line depreciation expense = [Cost of investment – Residual value] / Useful life

= [$3,000,000 - $200,000] / 10 Years

= $2,800,000 / 10 Years

= $280,000 per year

Annual net operating income = Annual net cash flow – Depreciation expenses

= $580,000 - $280,000

= $300,000

Average Investment = [Initial investment cost + Residual value] / 2

= [$3,000,000 + $200,000] / 2

= $3,200,000 / 2

= $1,600,000

Accounting Rate of Return (ARR) for Proposal-Y = [Annual net operating income / Average investment] x 100

= [$300,000 / $1,600,000] x 100

= 18.75%