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

Question

Average 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 $137,000 with a $12,000 residual value and a five-year life. The equipment will replace one employee who has an average wage of $52,405 per year. In addition, the equipment will have operating and energy costs of $13,250 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.
  %I got .1033 as my answer and rounded it to a whole percent which is 10%. This is (Incorrect)

Explanation / Answer

Answer:

Average Rate of Return measures the average annual net income of the project in % term of proposed investment. Here Net Income means Average Annual Net Income after Depreciation and Taxes

Average Rate of Return can be calculated one of the following formula.. Both formulas are correct for calculation of Average rate of return

1) If Initial Investment is considered

Average Rate of Return = Average Annaul Net Income after Depreciation & Tax / Intitial or Original Investment x 100

or

2) If Average Investment is considered

Average Rate of Return = Average Annaul Net Income after Depreciation & Tax / Average Investment x 100

As per First Formula, If Initial Investment is considered,

Average Rate of Return = $14,155 / $137,000 x 100 = 10.33%

As per Second Formula, If Average Investment is considered

Average Rate of Return = $14,155 / $74,500 x 100 = 19%

Average Investment = Salvage Value + 1/2 (Initial Investment - Salvage Value) = $12,000 + 1/2 ($137,000 - $12,000) = $12,000 + $62,500 = $74,500

Notes:

A) Calculation of Average Annual Net Income

B) Annual Depreciation = (Cost of Equipment - Residual Value)/ Useful life = ($137,000 - $12,000) / 5 = $25,000

Particulars Amount Annual Saving in Wages $52,405 Less: Annual Operating & Energy Cost ($13,250) Net Annual Income before Depreciation $39,155 Less: Annual Depreciation ($25,000) Annual Income After Depreciation $14,155

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