Accounting Rate of Return Each of the following scenarios is independent. Assume

Question

Accounting Rate of Return Each of the following scenarios is independent. Assume that all cash flows are after-tax cash flows. a. Cobre Company is considering the purchase of new equipment that will speed up the process for extracting copper. The equipment will cost $3,800,000 and have a life of 5 years with no expected salvage value. The expected cash flows associated with the project are as follows Cash Revenues $6,000,000 6,000,000 6,000,000 6,000,000 6,000,000 Year Cash Expenses $4,800,000 4,800,000 4,800,000 4,800,000 4,800,000 1- 2 4

Explanation / Answer

Formula for calculating ARR = Average Income/Average Investment

Year

Cash revenues

Cash Expenses

Annual Depreciation

Annual Income

1

6000000

4800000

760000

440,000

2

6000000

4800000

760000

440,000

3

6000000

4800000

760000

440,000

4

6000000

4800000

760000

440,000

5

6000000

4800000

760000

440,000

Annual Depreciation = Initial investment – Scrap Value / Number of years = 3800000- 0/5 = 760000

Annual Income = cash revenues – (Cash expenses + Annual Depreciation)

Average Investment = Initial Investment / 2 = 3800000/2 = 1900000

ARR =440000/1900000 = 0.231579% = 23.2%

2) Project A

Year

Cash inflows

Depreciation

Annual Income

1

22500

15000

7500

2

30000

15000

15000

3

45000

15000

30000

4

75000

15000

60000

5

75000

15000

60000

Initial investment = 75000

Total annual income = 172500

Average Annual Income = 172500/5 = 34500

Average Investment = 75000/2 = 34500/37500 = 92.0%

Project B

Year

Cash inflows

Depreciation

Annual Income

1

22500

15000

7500

2

30000

15000

15000

3

45000

15000

30000

4

22500

15000

7500

5

22500

15000

7500

Initial investment = 75000

Total annual income = 67500

Average Annual Income =67500 /5 = 13500

Average Investment = 75000/2 = 13500/37500 = 36.0%

We can select the project A because the ARR is high in the project.

3. Average net income as per the scenario C: 170000/0.30 = 566666.7

Total Investment = 566666.7*2 = 1133333

4. ARR = 50%

Investment = 150,000

Average Investment = 150,000/2 = 75,000

Average Net income = 75,000*50% = 37500

Year

Cash revenues

Cash Expenses

Annual Depreciation

Annual Income

1

6000000

4800000

760000

440,000

2

6000000

4800000

760000

440,000

3

6000000

4800000

760000

440,000

4

6000000

4800000

760000

440,000

5

6000000

4800000

760000

440,000

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