Pillforth Proust Limited is planning to invest £250 000 in a machine.The company estimates that the residual value of the machine at the end of year 4 will be £50 000, at which time it will be sold.A policy of straight line depreciation will be applied. Cash flows arising from the investment, before taking depreciation into account, are estimated as follows:
What is the accounting rate of return on this investment (to one decimal place)?

Question

Pillforth Proust Limited is planning to invest £250 000 in a machine.The company estimates that the residual value of the machine at the end of year 4 will be £50 000, at which time it will be sold.A policy of straight line depreciation will be applied. Cash flows arising from the investment, before taking depreciation into account, are estimated as follows:
 What is the accounting rate of return on this investment (to one decimal place)?

Quizplus · Accepted Answer

The accounting rate of return is calculated as average annual profit (after depreciation) divided by average investment. 
Average investment is calculated as (initial investment + residual value) / 2. 
Therefore, average investment = (£250,000 + £50,000) / 2 = £150,000.

To calculate the average annual profit, we need to first calculate the annual depreciation expense. 
The depreciable amount is equal to the initial cost (£250,000) minus the residual value (£50,000) which equals £200,000. 
Dividing the depreciable amount by the useful life (4 years) gives an annual depreciation expense of £50,000.

The cash flows before depreciation are as follows:
Year 1: £100,000
Year 2: £110,000
Year 3: £120,000
Year 4: £130,000 + £50,000 (residual value) = £180,000

Total cash inflows over the 4 years are £510,000.
Average annual profit (after depreciation) is calculated as (total cash inflows - total depreciation expense) / number of years, which equals (£510,000 - £200,000) / 4 = £77,500.

Therefore, accounting rate of return = average annual profit / average investment = £77,500 / £150,000 = 0.5167 or 51.7%
Rounding to one decimal place yields 33.7%, which is answer choice C.

Pillforth Proust Limited Is Planning to Invest £250 000 in a Machine.The