Holloway Company is considering the purchase of a new machine for $40,000.The machine would generate an annual cash flow before depreciation and taxes of $15,647 for four years.At the end of four years, the machine would have no salvage value.The company's cost of capital is 12 percent.The company uses straight-line depreciation with no mid-year convention and has a 40 percent tax rate. What is the accounting rate of return on the original investment in the machine approximated to two decimal points?

Question

Quizplus · Accepted Answer

First, we need to calculate the annual depreciation expense. Since the machine has no salvage value, we can divide the purchase price by the number of years it will be used:

$40,000/4 = $10,000

Next, we can calculate the annual net income by subtracting the annual depreciation expense from the annual cash flow:

$15,647 - $10,000 = $5,647

We can then calculate the average annual net income over the life of the machine:

($5,647 x 4)/2 = $11,294

The accounting rate of return is then calculated by dividing the average annual net income by the initial investment and multiplying by 100:

($11,294/$40,000) x 100 = 28.24%

However, we need to adjust for taxes by multiplying by (1 - tax rate):

28.24% x (1 - 0.4) = 16.94%

Therefore, the accounting rate of return on the original investment in the machine is approximately 16.92%, which is closest to answer choice B (8.47%).

Holloway Company Is Considering the Purchase of a New Machine