Nelson Corp.is considering the purchase of a new piece of equipment.The cost savings from the equipment would result in an annual increase in cash flow of $100,000.The equipment will have an initial cost of $400,000 and have a 5-year life.If the salvage value of the equipment is estimated to be $75,000,what is the accounting rate of return? Ignore income taxes.

Question

Quizplus · Accepted Answer

The Accounting Rate of Return (ARR) is calculated as the average annual profit from an investment divided by the initial cost of the investment. The average annual profit can be determined by adding the annual cash flow to the annualized salvage value and then subtracting the annual depreciation. The initial cost of the equipment is $400,000, and it has a 5-year life, so the annual depreciation is $400,000 / 5 = $80,000. The salvage value is $75,000, which when annualized over 5 years gives $75,000 / 5 = $15,000. Therefore, the average annual profit is $100,000 (annual cash flow) + $15,000 (annualized salvage value) - $80,000 (annual depreciation) = $35,000. The ARR is then $35,000 / $400,000 = 0.0875 or 8.75%.