Question

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 $220,000.
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  .

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

1) Formula Used:

a) ARR = (Average annual return / Initial Investment) * 100

b) Net Profit = Revenue - Expenses

c) Average annual return = Sum of Net profit / No. of years

	Revenue	Expenses	Net Profit
Year 1	6000000	4800000	1200000
Year 2	6000000	4800000	1200000
Year 3	6000000	4800000	1200000
Year 4	6000000	4800000	1200000
Year 5	6000000	4800000	1200000
Average Net profit	1200000
Initial Investment	3800000
Accounting Rate of return( ARR)	31.5%

2)

	Project A	Project B
Year 1	22500	22500
Year 2	30000	30000
Year 3	45000	45000
Year 4	75000	22500
Year 5	75000	22500
	247500	142500
Average Net profit	49500	28500
Initial Investment	75000	75000
Accounting Rate of return(ARR)	66%	38%

• Project A has higher ARR as compared to Project B. Hence Project A should be preferred by Emily Hansen.

• Advantage of using ARR over Payback period method:

  • It takes into consideration the profits of the entire life of the project.

  • It helps measure the profitability of a proposed project.

3)

As per information provided in point (c),

• Average annual return = 220000
• ARR = 30% = 30/100

By using formula of ARR (in %age) i.e.

ARR = (Average annual return / Initial Investment)

30/100 = (220000 / Intial Investment)

Initial Investment = 733333.33

4)

As per information provided in point (d),

• Average annual return = 225000
• ARR = 50% = 50/100

By using formula of ARR (in %age) i.e.

ARR = (Average annual return / Initial Investment)

50/100 = (225000 / Intial Investment)

Initial Investment = 450000