Question

Accounting Rate of Return

WeCare Clinic is planning on investing in some new echocardiogram equipment that will require an initial outlay of $150,000. The system has an expected life of five years and no expected salvage value. The investment is expected to produce the following net cash flows over its life: $74,000, $69,000, $90,000, $92,000, and $92,000.

Required:

1. Calculate the annual net income for each of the five years.

Net Income

Year 1 $

Year 2 $

Year 3 $

Year 4 $

Year 5 $

2. Calculate the accounting rate of return. Enter your answer as a whole percentage value (for example, 16% should be entered as "16").

%

3. What if a second competing revenue-producing investment has the same initial outlay and salvage value but the following cash flows (in chronological sequence): $92,000, $92,000, $92,000, $74,000, and $33,500? Calculate its accounting rate of return. Enter your answer as a whole percentage value (for example, 16% should be entered as "16").

%

3b. Using the accounting rate of return metric, which project should be selected: the first or the second?

3c. Why might the second project be preferred over the first project? It returns larger amounts of cash sooner than the first project

Answer 1

1. Calculate the annual net income for each of the five years.:

Note: Depreciation would be considered for calculating the annual net income and accounting rate of return. it is assumed that straight line method of depreciation will be used by company.

Depreciation per year =($150,000 Cost - $0 Salvage Value) / 5 Years of Useful life = $30,000.

2. Calculate the accounting rate of return. Enter your answer as a whole percentage value (for example, 16% should be entered as "16"):

Accounting rate of return = Total of accounting rate of return/ 5 Year

Accounting rate of return = 178/5

Accounting rate of return = 36

3. What if a second competing revenue-producing investment has the same initial outlay and salvage value but the following cash flows (in chronological sequence): $92,000, $92,000, $92,000, $74,000, and $33,500? Calculate its accounting rate of return. Enter your answer as a whole percentage value (for example, 16% should be entered as "16").

Accounting rate of return = Total of accounting rate of return/ 5 Year

Accounting rate of return = 156/5

Accounting rate of return = 31

3b. Using the accounting rate of return metric, which project should be selected: the first or the second?

Accounting rate of return metric
	Rate
Option 1	36
Option 2	31

Using the accounting rate of return the option 1 will be selected because of the higher rate of return.

3c. Why might the second project be preferred over the first project? It returns larger amounts of cash sooner than the first project

The second project can be prefered over the first project if we are considering the cash flows to be recognised by net present value. if we consider the net present value method then second project may be selected because of the initial cash flows will be higher than the first project.

the second reason is that because of higher initial cash flows the payback periaod of second project is lower than that of first project and hence cost recovery is made earlier than project one.