Morrow Company is considering a purchase of equipment that costs $70,000.The equipment has a 7-year life and no salvage value.Morrow uses straight-line depreciation.The equipment has a payback period of 4 years.The accounting rate of return is closest to
A)3.5%.
B)10.7%.
C)25%.
D)39%.

Question

Quizplus · Accepted Answer

To calculate the accounting rate of return, we need to find the average annual net income from the equipment and divide it by the average investment in the equipment.

Average annual net income = Total net income / Life of equipment
Total net income = Revenue - Expenses - Depreciation
Revenue and expenses are not given, so we can assume they cancel each other out as they are equal.

Depreciation = Cost of equipment / Life of equipment = 70,000/7 = 10,000

Total net income = 0 - 10,000 = -10,000 (assuming no revenue)

Average annual net income = (-10,000) / 7 = -1,428.57

Average investment = (Initial investment + Salvage value) / 2
Since there is no salvage value, 
Average investment = Initial investment / 2 = 70,000 / 2 = 35,000

Accounting rate of return = (Average annual net income / Average investment) x 100%
= (-1,428.57 / 35,000) x 100%
= -0.0408 x 100%
= -4.08%

Since the accounting rate of return is negative, it means that the investment does not meet the minimum desired rate of return and should be rejected.

Therefore, the best choice is B, as it is not within the choices and we can assume that the investment should not be made.

Morrow Company Is Considering a Purchase of Equipment That Costs