Eco Wet, Inc., a manufacturer of gears for lawn sprinklers, is thinking about ad

Question

Eco Wet, Inc., a manufacturer of gears for lawn sprinklers, is thinking about adding a new fully automated machine. This machine can produce gears that the company now produces on its third shift. The machine has an estimated useful life of ten years and will cost $500,000. The residual value of the new machine is $50,000. Gross cash revenue from the machine will be about $420,000 per year, and related operating expenses, including depreciation, should total $400,000. Depreciation is estimated to be $80,000 annually. Management has decided that only capital investments that yield at least an 8 percent return will be accepted. Using the accounting rate-of-return method, decide whether the company should invest in the machine.

Explanation / Answer

Accounting rate of return is computed using the following formula:

Accounting rate of return = Average accounting profit / Average investment

Where,

Average accounting profit = Annual profit (When profit for each year is same)

= Gross cash revenue - Operating expenses

= $420,000 - $400,000

= $20,000

Average investment = (Initial investment + salvage value) / 2

= ($500,000 + $50,000) / 2

= 275,000

Therefore,

Accounting rate of return = $20,000 / $275,000 = 0.073 or 7.3%

The accounting rate of return for the investment in the machine is less than 8%.

Since the management has decided that only capital investments that yield at least an 8 percent return will be accepted, the company should not invest in the machine.

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