You’re trying to determine whether or not to expand your business by building a
ID: 2719637 • Letter: Y
Question
You’re trying to determine whether or not to expand your business by building a new manufacturing plant. The plant has an installation cost of $20.2 million, which will be depreciated straight-line to zero over its four-year life.
If the plant has projected net income of $1,895,000, $2,185,000, $2,114,000, and $1,366,000 over these four years, what is the project’s average accounting return (AAR)? (Do not round intermediate calculations. Enter your answer as a percentage rounded to 2 decimal places (e.g., 32.16).)
You’re trying to determine whether or not to expand your business by building a new manufacturing plant. The plant has an installation cost of $20.2 million, which will be depreciated straight-line to zero over its four-year life.
Explanation / Answer
Formula
Accounting Rate of Return is calculated using the following formula:
ARR = Average accounting profit/ Average investment
Average accounting profit is the arithmetic mean of accounting income expected to be earned during each year of the project's life time. Average investment may be calculated as the sum of the beginning and ending book value of the project divided by 2. Another variation of ARR formula uses initial investment instead of average investment
Annual depreciation = $20200000/4 = $5050000
It is assumed that net income given in question is after deduction of depreciation expense
Therefore average accounting profit = (1895000+2185000+2114000+1366000)/4 = $1890000
Now we calculate ARR based on both initial investment as well as average investment
Initial investment
ARR = 1890000*100/20200000 = 9.3564 I.e. 9.36%
Average investment
ARR = 1890000*100/[(20200000+0)/2] = 18.7128% I.e. 18.71%
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