You’re trying to determine whether to expand your business by building a new man

Question

You’re trying to determine whether to expand your business by building a new manufacturing plant. The plant has an installation cost of $11.9 million, which will be depreciated straight-line to zero over its four-year life. If the plant has projected net income of $1,844,300, $1,897,600, $1,866,000, and $1,319,500 over these four years, what is the project’s average accounting return (AAR)? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) Average accounting return %

Explanation / Answer

Solution:

Average Accounting Return (ARR) is the ratio of average accounting profit to the average book value of the investment over the investment period. It is calculated by using the following formula:

                ARR = Average accounting profit/ Average book value
where Average accounting profit = Total accounting profit over the investment period/years of investment
and Average book value = (Initial investment + Residual value + Working capital)/2

In the given case, Sum of all projected net income = (1844300+1897600+1866000+1319500) = $6,927,400
Average accounting profit = 6927400/4 = $1,731,850 -------------------- (1)

Now, Initial investment = $11,900,000 , Residual value = 0, Wowrking capital = 0,
hence Average book value = (11,900,000+0+0)/2 = $5,950,000 --------------- (2)

So, divide 1 by 2
                  1,731,850/5,950,000
             = 0.29107
or ARR = 29.11%

hence, the Average Accounting Return is equal to 29.11%

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