Johnson Whole Distributors is anticipating investing in equipment that cost $120,000.The equipment has an 8-year life and no salvage value.Johnson uses straight-line depreciation.The equipment has a payback period of 5 years.The accounting rate of return is closest to
A)5%.
B)6.25%.
C)7.8%.
D)7.5%.

Question

Quizplus · Accepted Answer

The Accounting Rate of Return (ARR) is calculated as the average annual profit divided by the initial investment. Here, the equipment costs $120,000 and is depreciated straight-line over 8 years, so annual depreciation is $120,000 / 8 = $15,000. With a payback period of 5 years, the equipment generates enough cash flow to recover its initial cost in 5 years, implying annual cash flows of $24,000 ($120,000 / 5 years). The annual profit (ignoring taxes and interest) is the annual cash flow minus annual depreciation, which is $24,000 - $15,000 = $9,000. Therefore, the ARR = ($9,000 / $120,000) * 100% = 7.5%.

Johnson Whole Distributors Is Anticipating Investing in Equipment That Cost