Axe Corporation is considering investing in a machine which has a cost of $25,00

Question

Axe Corporation is considering investing in a machine which has a cost of $25,000. The estimated life of the machine is 5yrs, with no salvage value. Axe anticipates annual net income after taxes of $1,500 from selling the product produced by the new machine. What is Axe's rate of return on average investment assuming the Axe uses straight-line depreciation and that the annual production is sold at the end of each year?
a. 6.0 percent b. 8.0 percent c. 10.0 percent d. 12.0 percent


please show work

Explanation / Answer

Initial cost of the machine = $25,000

Estimated life of the machine = 5 years

Annual net income (after taxes) = $1,500

Rate of Return on Average Investment = [Average Net Income / Average book value]

Calculating Rate of Return on Average Investment:

To calculate the average book value for this investment, we note that we started out with a book value of $25,000 (the initial cost) and ended up at $0. The average book value during the life of the investment in thus ($25,000 + $0) / 2 = $12,500. As long as we use straight-line depreciation and a zero salvage value, the average investment will always be one-half of the initial investment.

Average Net Income = [$1,500 + $1,500 + $1,500 + $1,500 + $1,500] / 5

Average Net Income = $1,500

Rate of return on Average investment = [$1,500 / $12,500] = 0.12 (or) 12%

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