Smith & Cramer, Computer Repair, is considering an investment in computer and network equipment costing $240,000. This equipment would allow them to offer new programming services to clients. The equipment will be depreciated on the straight-line basis over an eight-year period with an estimated residual value of $50,000. Using the accounting rate of return model, what is the minimum average annual operating income that must be generated from this investment in order to achieve an 11% accounting rate of return?

Question

Quizplus · Accepted Answer

The minimum average annual operating income needed to achieve an 11% accounting rate of return can be calculated as follows: First, find the average investment, which is the sum of the initial cost and the residual value divided by 2. This equals ($240,000 + $50,000) / 2 = $145,000. Then, to find the minimum average annual operating income, multiply the average investment by the desired rate of return, 11%. So, $145,000 * 0.11 = $15,950. However, this calculation does not account for the depreciation expense, which must be added back to meet the target return. The annual depreciation is ($240,000 - $50,000) / 8 = $23,750. Therefore, the total minimum average annual operating income is $15,950 (desired return) + $23,750 (depreciation) = $39,700. This option is not provided, indicating a mistake in my calculation. Correcting this: The correct calculation for the accounting rate of return (ARR) is based on the average annual operating income above depreciation. The initial calculation of the ARR target involves the average investment, which was correctly identified as $145,000. However, the correct approach to find the minimum average annual operating income is to consider the initial investment's depreciation and the desired return on the average investment. The depreciation is correctly calculated as $23,750 annually. To achieve an 11% return on the average investment of $145,000, the annual return should be 11% of $145,000, which is $15,950. This error in adding depreciation to this figure suggests a misunderstanding. The correct calculation should focus on the net operating income required to achieve the desired ARR, which involves the average investment and desired return rate without incorrectly adding back the annual depreciation since it's a non-cash expense that doesn't affect the cash return required. Given the options and the mistake in the explanation, the correct approach involves recalculating based on the provided options and the understanding that the ARR is calculated without incorrectly adding depreciation to the desired return. The correct answer should reflect the average annual operating income required to meet the ARR target, considering the investment's cost, residual value, and the straight-line depreciation method over its useful life.

Smith & Cramer, Computer Repair, Is Considering an Investment in Computer