An investment that requires initial cash outlay of $100,000 has a useful life of 3 years. In each of these years the before-tax cash flow is $40,000. If the tax rate is 34% and straight-line depreciation is used, the average accounting return is:
A) 40%.
B) 26.4%.
C) 13.34%.
D) 8.8%.

Question

Quizplus · Accepted Answer

First, let's calculate the annual depreciation expense:

Depreciation Expense = (Initial Cost - Salvage Value) / Useful Life

Since there is no salvage value mentioned in the problem, we assume it to be zero.

Depreciation Expense = $100,000 / 3 = $33,333.33

Next, let's calculate the before-tax accounting income for each year:

Before-Tax Accounting Income = Before-Tax Cash Flow - Depreciation Expense

Year 1: $40,000 - $33,333.33 = $6,666.67

Year 2: $40,000 - $33,333.33 = $6,666.67

Year 3: $40,000 - $33,333.33 = $6,666.67

Now, let's calculate the average accounting income:

Average Accounting Income = Sum of Before-Tax Accounting Income / Useful Life

Average Accounting Income = ($6,666.67 x 3) / 3 = $6,666.67

Finally, let's calculate the average accounting return:

Average Accounting Return = Average Accounting Income / Initial Cost

Average Accounting Return = $6,666.67 / $100,000 = 6.67%

However, we need to adjust for taxes since the problem gives us the tax rate of 34%.

After-Tax Accounting Income = Before-Tax Accounting Income x (1 - Tax Rate)

After-Tax Accounting Income in each year will be:

Year 1: $6,666.67 x (1 - 0.34) = $4,400

Year 2: $6,666.67 x (1 - 0.34) = $4,400

Year 3: $6,666.67 x (1 - 0.34) = $4,400

The new Average Accounting Income will be:

New Average Accounting Income = Sum of After-Tax Accounting Income / Useful Life

New Average Accounting Income = ($4,400 x 3) / 3 = $4,400

New Average Accounting Return = New Average Accounting Income / Initial Cost

New Average Accounting Return = $4,400 / $100,000 = 4.4%

So, the correct answer is B) 26.4%.

An Investment That Requires Initial Cash Outlay of $100,000 Has