Question

Accounting Rate of Return

WeCare Clinic is planning on investing in some new echocardiogram equipment that will require an initial outlay of $165,000. 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: $72,000, $85,000, $94,000, $91,000, and $96,000.

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): $96,000, $96,000, $96,000, $72,000, and $39,000? Calculate its accounting rate of return. Enter your answer as a whole percentage value (for example, 16% should be entered as "16").
%

Answer 1

1)The annual net income for each of the five years is calculated below:

Depreciation p.a = (Cost - Salvage Value)/ Useful Life

= ($165,000 - $0)/ 5 Years

= $165,000/5

= $33,000

Net Income = Net cash flows - Depreciation p.a

Year	Net Income
Year 1	$72,000 - $33,000 = $39,000
Year 2	$85,000 - $33,000 = $52,000
Year 3	$94,000 - $33,000 = $61,000
Year 4	$91,000 - $33,000 = $58,000
Year 5	$96,000 - $33,000 = $63,000

2)Accounting rate of return is calculated below:

Accounting rate of return = Average Net Income/ Initial Investment*100

Average Net Income   = Total Income / No.of Years

=($39,000 + $52,000 + $61,000 + $58,000 + $63,000)/ 5 Years

= $273,000/ 5 Years

= $54,600

Accounting rate of return = $54,600/$165,000*100

= 33.09

3)Accounting rate of return = Average Net Income/ Initial Investment*100

Depreciation p.a = (Cost - Salvage Value)/ Useful Life

= ($165,000 - $0)/ 5 Years

= $165,000/5

= $33,000

Average Annual Cash Flow = ($96,000 + $96,000 + $96,000 + $72,000 + $39,000)/ 5 Years

= $399,000/ 5 Years

= $79,800

Average Net Income = Average Annual Cash Flow - Depreciation p.a

= $79,800 - $33,000

= $46,800

Accounting rate of return = Average Net Income/ Initial Investment*100

= $46,800/$165,000*100

= 28.36