The expected average rate of return for a proposed investment of $800,000 in a fixed asset with a useful life of four years, straight-line depreciation, no residual value, and an expected total net income of $360,000 for the four years is

Question

Quizplus · Accepted Answer

First, we need to calculate the annual net income:
$360,000 / 4 years = $90,000 per year

Next, we need to calculate the annual depreciation:
$800,000 / 4 years = $200,000 per year

The annual earnings before interest and taxes (EBIT) can be calculated as follows:
Annual net income + Annual depreciation = EBIT
$90,000 + $200,000 = $290,000

To calculate the expected average rate of return, we need to use the following formula:
Expected average rate of return = EBIT / Initial investment

Expected average rate of return = $290,000 / $800,000 = 0.3625 or 36.25%

However, we need to remember that the above calculation does not take into account the time value of money. To adjust for this, we can use the following formula:
Expected average rate of return = (1 + Return on investment)^n - 1
where n is the number of years and Return on investment is the annual rate of return.

Using the values from above, we get:
Expected average rate of return = (1 + 0.3625)^4 - 1 = 1.774 or 177.4%

To get the annual rate of return, we divide the expected average rate of return by the number of years:
Annual rate of return = 177.4% / 4 years = 44.35%

Since this value is closest to 22.5%, we choose answer choice B as the best answer.

The Expected Average Rate of Return for a Proposed Investment