Kahlen Upholstery is considering entering a new line of operations. Starting the business will require an initial investment in equipment of $400,000 with a salvage value of $40,000. It is expected that the new business will increase net income by $80,000 per year for five years. The equipment will be depreciated over a five-year period using straight-line depreciation with no residual value. How much is the accounting rate of return of the new business?

Question

Quizplus · Accepted Answer

The accounting rate of return is calculated by dividing the average annual income by the initial investment.

Average Annual Income = (Net income + Depreciation) / 2
Net income = $80,000 per year for 5 years = $400,000
Depreciation = ($400,000 - $40,000) / 5 = $72,000 per year

Average Annual Income = ($400,000 + $72,000) / 2 = $236,000

Accounting Rate of Return = Average Annual Income / Initial Investment
                       = $236,000 / $400,000
                       = 0.59 or 59%
                       
Therefore, the accounting rate of return of the new business is 36.4% (Option C).

Kahlen Upholstery Is Considering Entering a New Line of Operations