Lennon Corporation is contemplating an investment in new equipment costing $650,000. The equipment will be depreciated on a straight-line basis over a seven-year life and is expected to have a salvage value of $20,000. The equipment is expected to increase cash operating expenses by $200,000 per year. How much would the annual revenues have to be in order to achieve an accounting rate of return of 10%?

Question

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The Accounting Rate of Return (ARR) is calculated as the average annual profit divided by the initial investment. The average annual profit can be found by subtracting the annual operating expenses and annual depreciation from the annual revenues. The initial investment is the cost of the equipment, and the annual depreciation is calculated as (Initial Cost - Salvage Value) / Useful Life.1. Calculate annual depreciation: ($650,000 - $20,000) / 7 = $90,000 per year.2. To achieve a 10% ARR, the average annual profit must be 10% of the initial investment: 10% of $650,000 = $65,000.3. The average annual profit is the difference between annual revenues and the sum of annual operating expenses and annual depreciation. So, $65,000 = Annual Revenues - ($200,000 + $90,000).4. Solving for Annual Revenues gives: Annual Revenues = $65,000 + $200,000 + $90,000 = $355,000.However, the correct calculation for the required annual revenues to achieve a 10% ARR, considering the error in the explanation, should involve correctly identifying the net initial investment and the target return based on that investment. The mistake in the calculation process led to an incorrect conclusion. The correct approach involves determining the net profit required to achieve the desired ARR and then adding back the operational and depreciation expenses to find the necessary revenue.

Lennon Corporation Is Contemplating an Investment in New Equipment Costing