Question

Accounting Rate of Return

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

Cobre Company is considering the purchase of new equipment that will speed up the process for extracting copper. The equipment will cost $4,000,000 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

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

c. Suppose that a project has an ARR of 30% (based on initial investment) and that the average net income of the project is $220,000.

d. Suppose that a project has an ARR of 50% and that the investment is $225,000.

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?
$

Answer 1

Problem 1 --- Accounting Rate of Return

Accounting Rate of Return

Accounting rate of return is a technique of capital budgeting to evaluate the proposed investment. It considers the Net Profit after tax as per Profit and loss. This method does not consider Cash Flow and time value of money.

Accounting Rate of Return can be calculated by following ways:

1) Based on Total Initial Investment

2) Based on Average Investment

Accounting Rate of Return (based on total initial investment) = Average Annual Net Profit after tax / Total Investment Amount x 100

Year	Cash Revenues	Cash Expenses	Net Profit (Cash Revenue - Cash Expense)
1	$6,000,000	$4,800,000	$1,200,000
2	$6,000,000	$4,800,000	$1,200,000
3	$6,000,000	$4,800,000	$1,200,000
4	$6,000,000	$4,800,000	$1,200,000
5	$6,000,000	$4,800,000	$1,200,000
	TOTAL		$6,000,000

Average Annual Profit After Tax = Total Profit / Number of Years = $6,000,000 / 5 = $1,200,000

Initial Total Investment = $4,000,000

Accounting Rate of Return (based on initial investment) = $1,200,000 /$4,000,000 x 100 = 30%

Accounting Rate of Return (based on average investment) = Average Annual Net Profit after tax / Average Investment Amount x 100

Average Investment = (Initial Investment + Salvage Value) / 2 = (4,000,000 + 0)/2 = $2,000,000

Accounting Rate of Return (based on average investment) = Average Annual Net Profit after tax 1,200,000 / Average Investment Amount 2,000,000 x 100

= 60%

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