Question

What is the average accounting rate of return(APR) on a piece of equipment that will cost $ 1.2 million and that will result in pretax cost savings of $380,000 for the first three years and then $280,000 for the following three years? Assume that the machinery will be depreciated to a salvage value of 0 over six years using the straight line method and the company’s tax rate if 32 percent. If the acceptance decision is based on the project exceeding an APR OF 20 percent, should this machinery be purchased?

Answer 1

Average Accounting rate of return = Average Net Income / Initial Investment in equipment
Calculation of Average net Income
Year	1	2	3	4	5	6
Pretax cost savings	$380,000.00	$380,000.00	$380,000.00	$280,000.00	$280,000.00	$280,000.00
Less : Depreciation	$200,000.00	$200,000.00	$200,000.00	$200,000.00	$200,000.00	$200,000.00
Profit before tax	$180,000.00	$180,000.00	$180,000.00	$80,000.00	$80,000.00	$80,000.00
Less : Tax @ 32%	$57,600.00	$57,600.00	$57,600.00	$25,600.00	$25,600.00	$25,600.00
Net Income	$122,400.00	$122,400.00	$122,400.00	$54,400.00	$54,400.00	$54,400.00
Average net income = Sum of net income for 6 years / Number of Years = $5,30,400 / 6 years = $88,400
Average Accounting rate of return = $88,400 / $12,00,000
Average Accounting rate of return = 7.37%
The machinery should not be purchased as it's Average accounting rate of return is less than 20%
Working
Depreciation per year = Cost of equipment / useful life = $12,00,000 / 6 years = $2,00,000