verage Rate of Return—Cost Savings Master Fab Inc. is considering an investment

Question

verage Rate of Return—Cost Savings

Master Fab Inc. is considering an investment in equipment that will replace direct labor. The equipment has a cost of $129,000 with a $11,000 residual value and a five-year life. The equipment will replace one employee who has an average wage of $48,010 per year. In addition, the equipment will have operating and energy costs of $12,510 per year.

Determine the average rate of return on the equipment, giving effect to straight-line depreciation on the investment. If required, round to the nearest whole percent.
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Explanation / Answer

Average rate of return is the rate of return earned by a project over its life time. For Master Fab, we need find out average rate of return on Cost savings by purchasing new equipment. To calculate average rate of return, cash inflows and cash outflows over the life time of the asset is required. As we are calculating for cost savings, Cost of the equipment, depreciation and operating and energy costs on the asset will be considered as cash outflow. The direct labor cost which is saved will be taken as cash inflow.

Depreciation is calculated using straight line method

Equipment cost - $129,000

Residual value - $11,000

Life of the asset – 5 years.

Depreciation = ($129,000 - $11,000)/5 = $23,600

Annual operating and energy costs = $12,510

So cash outflow in each year = $23,600 + $12,510 = $36,110

Direct labor cost saved is $ 48,010

The cash flows in each year will be as follows:

Year

Cash Outflow

Cash Inflow

Net cash flow

Balance

Year 0

($129,000)

($129,000)

($129,000)

Year 1

($36,110)

$48,010

$11,900

($117,100)

Year 2

($36,110)

$48,010

$11,900

($105,200)

Year 3

($36,110)

$48,010

$11,900

($ 93,300)

Year 4

($36,110)

$48,010

$11,900

($ 81,400)

Year 5

($36,110)

$48,010

$11,900

($ 69,500)

So after the life of the asset the cumulative net cash flow is negative $69,500

So Average rate of return on cost savings is calculated as

(Total Cost Savings/Life time of asset)/Initial investment * 100

= (-$69,500/5)/$129,000 * 100

= -$13,900/$129,000 * 100

= - 11% (Rounded off to nearest whole percent)

Year

Cash Outflow

Cash Inflow

Net cash flow

Balance

Year 0

($129,000)

($129,000)

($129,000)

Year 1

($36,110)

$48,010

$11,900

($117,100)

Year 2

($36,110)

$48,010

$11,900

($105,200)

Year 3

($36,110)

$48,010

$11,900

($ 93,300)

Year 4

($36,110)

$48,010

$11,900

($ 81,400)

Year 5

($36,110)

$48,010

$11,900

($ 69,500)

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