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 $80,000 with a $7,000 residual value and a five-year life. The equipment will replace one employee who has an average wage of $28,865 per year. In addition, the equipment will have operating and energy costs of $7,740 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. %

Explanation / Answer

Investment = Cost of Machine = $80,000

Depreciation per year = (Cost – Residual value) / Useful life

= ($80,000 – 7,000) / 5 Years

Depreciation per year = $14,600 per year

Profit / Return = Saving in wages – Operating and energy cost - Depreciation

= $28,865 – 7,740 - 14,600

= $6,525

ARR = Profit / Average Investment

= $6,525 / $80,000

Average Rate of return = 8.16%

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