Hollister Company is considering the purchase of a new machine for $60,000. The machine would generate an annual cash flow before depreciation and taxes of $25,647 for four years. At the end of four years, the machine would have no salvage value. The company's cost of capital is 12 percent. The company uses straight-line depreciation with no mid-year convention and has a 40 percent tax rate. What is the accounting rate of return on the original investment in the machine approximated to two decimal points?

Question

Quizplus · Accepted Answer

The accounting rate of return (ARR) is calculated as the average annual accounting profit divided by the initial investment. Accounting profit is calculated as the annual cash flow before tax and depreciation minus the annual depreciation expense and minus taxes on depreciation.

Initial investment = $60,000
Annual cash flow before tax and depreciation = $25,647
Depreciation expense = $60,000 / 4 = $15,000 per year
Tax rate = 40%

Annual accounting profit = ($25,647 - $15,000) x (1 - 0.4) = $6,388.20

ARR = $6,388.20 / $60,000 = 0.1064667 or 10.65% (approximated to two decimal points)

Therefore, the best choice is C as it is the correct accounting rate of return on the original investment in the machine.

Hollister Company Is Considering the Purchase of a New Machine