Question

The projected net cash flows for a project are (in $thousands):

Year Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

$(350) $40 $100 $210 $260 $160

Assuming the initial investment is depreciated over the life of the project, the accounting rate of return for the project is

Select one:

a. 40%

b. 25%

c. 48%

d. 33%

Answer 1

The solution is as follows:

1) Calculation of annual depreciation expense:

(Cost - salvage value) /life of asset.

In this problem, Cost = $ 350000; life of asset = 5 years

Thus annual depreciation expense = $350000/5 = $ 70000

2) Computation of average incremental annual income:

Particulars	Year 1	Year 2	Year 3	Year 4	Year 5
Expected revenues (cash inflows)	$ 40000	$ 100000	$ 210000	$ 260000	$ 160000
Less: Depreciation expense	$ 70000	$ 70000	$ 70000	$ 70000	$ 70000
Net operating income	$ (30000)	$ 30000	$ 140000	$ 190000	$ 90000

Average income = (-30000 + 30000 + 140000 + 190000 + 90000)/5 =$ 420000/5 = $ 84000

3) Computation of accounting rate of return:

Accounting rate of return = Incremental accounting income/Initial investment

Average income = $ 84000; Initial investment = $ 350000

Accounting rate of return = $ 84000/ $ 350000 * 100= 24% (which is equivalent to 25%)

Hence option (b) is the correct answer