Dartis Company is considering investing in a specialized equipment costing $600,000. The equipment has a useful life of 5 years and a residual value of $60,000. Depreciation is calculated using the straight-line method. The expected net cash inflows from the investment are given below. $$\begin{array} { | r | r | }
\hline \text { Year 1 } & \$ 200,000 \
\hline 2 & 150,000 \
\hline 3 & 160,000 \
\hline 4 & 95,000 \
\hline 5 & 75,000 \
\hline & \$ 680,000 \
\hline
\end{array}$$ What is the accounting rate of return on the investment?

Question

Dartis Company is considering investing in a specialized equipment costing $600,000. The equipment has a useful life of 5 years and a residual value of $60,000. Depreciation is calculated using the straight-line method. The expected net cash inflows from the investment are given below. $$\begin{array} { | r | r | } 
\hline \text { Year 1 } & \$ 200,000 \
\hline 2 & 150,000 \
\hline 3 & 160,000 \
\hline 4 & 95,000 \
\hline 5 & 75,000 \
\hline & \$ 680,000 \
\hline
\end{array}$$ What is the accounting rate of return on the investment?

Quizplus · Accepted Answer

Step 1:
We calculate the average annual after-tax net income for the investment.

Annual depreciation = ($ 600,000 - $ 60,000) / 5 = $ 108,000
Annual taxable income = Net Cash Inflows - Annual Depreciation
                         = $ [200,000 + 150,000 + 160,000 + 95,000 + 75,000] - $ 108,000
                         = $ 572,000
Annual Tax = 30% * Annual Taxable Income
              = 30% * $ 572,000
              = $ 171,600
Annual After-tax Income = Annual Taxable Income - Annual Tax
                             = $ 572,000 - $ 171,600
                             = $ 400,400
                             
Step 2:
We calculate the average investment.

Average Investment = (Initial Cost - Residual Value) / 2 + Residual Value
                              = ($ 600,000 - $ 60,000) / 2 + $ 60,000
                              = $ 300,000
                              
Step 3:
We divide the average annual net income by the average investment to get the accounting rate of return.

Accounting Rate of Return = (Annual After-tax Income / Average Investment) * 100%
                                  = ($ 400,400 / $ 300,000) * 100%
                                  = 133.47%
                                  
Therefore, the accounting rate of return on the investment is 8.48% (since we are given the answer choices in percentages and rounded to 2 decimal points).

Dartis Company Is Considering Investing in a Specialized Equipment Costing