Webster Corp. is considering producing a new waxing product, Glisten. Research has determined that the company will be able to sell 50,000 units per year at $13. The product will be produced in a section of an existing factory that is currently not in use. To produce Glisten, Webster must buy a machine that costs $380,000. The machine has an expected life of five years and will have an ending residual value of $40,000. Webster will depreciate the machine over five years using the straight-line method. In addition to the cost of the machine, the company will incur incremental manufacturing costs of $535,000. Webster has an income tax rate of 30 percent, and the company's required rate of return is 7 percent. How much is the accounting rate of return?

Question

Quizplus · Accepted Answer

To calculate the accounting rate of return, we need to divide the average annual operating income by the initial investment.

First, let's calculate the average annual operating income:

Annual Revenue = 50,000 units x $13 = $650,000
Incremental Manufacturing Costs = $535,000
Depreciation Expense = ($380,000 - $40,000) / 5 = $68,000
Annual Operating Income = Annual Revenue - Incremental Manufacturing Costs - Depreciation Expense = $47,000

Next, let's calculate the initial investment:

Initial Investment = Machine Cost = $380,000

Now we can calculate the accounting rate of return:

ARR = Average Annual Operating Income / Initial Investment x 100%
ARR = $47,000 / $380,000 x 100%
ARR = 12.4%

However, we need to adjust for taxes since the company has an income tax rate of 30%. Let's calculate the after-tax operating income:

After-Tax Operating Income = Annual Operating Income x (1 - Tax Rate)
After-Tax Operating Income = $47,000 x (1 - 0.30) = $32,900

Now we can recalculate the accounting rate of return:

ARR = After-Tax Operating Income / Initial Investment x 100%
ARR = $32,900 / $380,000 x 100%
ARR = 8.7%

Therefore, the accounting rate of return for the Glisten product is 8.7%. The best choice is C.