Question

The company's management is considering a new 8 year project. The project will require the purchase of a new piece of equipment at a cost of $600,000. The equipment will last eight years and have no salvage value at the end of its life. This project will generate incremental net cash revenues eah year duing the assets life in the amount of $140,000. The company uses straight-line depreciation and requires a minumum of 10% return on all new projects.

1. Using simple rate of return, should the project be accpeted? why or why not?

2. Explain strenghts and weaknesses of using rimple rate of return

Answer 1

Solution 1:

Investment in new project = $600,000

Annual deprecaition = $600,000 / 8= $75,000

Annual income from new project = $140,000 - $75,000 = $65,000

Simple rate of return = Average annual income / Initial investment = $65,000 / $600,000 = 10.8333%

As minimum required return of project is 10% and this project is providing 10.833% return, therefore project should be accepted.

Solution 2:

The strength of simple rate of return is that it is simple and easy to calculate but there are various weakness of simple rate of return. These are as under:

Time value of money - The method does not use discounting to reduce the incremental amount of net income to its present value. This failure overstates the rate of return. Thus, the method assumes that net income earned several years from now has the same value as net income earned in the present.

Cash flow:. The method uses net income in the numerator of the calculation, rather than cash flows. Cash flows are considered the best method of judging the return on an investment.

Constant profit stream: The method assumes that a business earns the same income in period after period, however reality is income will change over the time.