An investment proposal is expected to have the following characteristics: Invest
ID: 2648485 • Letter: A
Question
An investment proposal is expected to have the following characteristics: Investments occur during the year and allow the indicated earnings, but both the income and investments are considered to have been made at the end of each year for the analysis purposes. In any year in which deductions exceed income, the tax benefits can be considered as additional income because the organization can apply the deductions against income earned from others operations. a) Determine the rate of return before taxes. b) If the effective income tax rate is 42 percent, what is the approximate after-tax rate of return? c) What is the actual after-tax rate of return?Explanation / Answer
Accounting rate of return (ARR): This is the ratio of average annual profit and average investment. ARR is required for investment appraisal.
Computation of average annual profit and average investment:
Heads
Year 1
Year 2
Year 3
Total
Gross income
$17,000
$22,000
$19,000
$58,000
Less: Operating expense
$6,000
$8,000
$11,000
$25,000
Less: Depreciation expense
$10,000
$10,000
$10,000
$30,000
Net income before tax
$1,000
$4,000
-$2,000
$3,000
Average net income before tax
($3,000 / 3 years)
$1,000
Investment
$16,000
$14,000
$0
$30,000
Average investment
($30,000 / 3 years)
$10,000
a. Accounting rate of return before tax = Average net income before tax / Average investment
= ($1,000 / $10,000)
Heads
Year 1
Year 2
Year 3
Total
Gross income
$17,000
$22,000
$19,000
$58,000
Less: Operating expense
$6,000
$8,000
$11,000
$25,000
Less: Depreciation expense
$10,000
$10,000
$10,000
$30,000
Net income before tax
$1,000
$4,000
-$2,000
$3,000
Average net income before tax
($3,000 / 3 years)
$1,000
Investment
$16,000
$14,000
$0
$30,000
Average investment
($30,000 / 3 years)
$10,000
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