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Newman Labs is considering buying equipment,which would enable the company to obtain a five-year research contract.The specialized equipment costs $650,000 and will have no salvage value when the five-year contract period is over.The estimated annual operating results of the project are as follows:
All revenue from the contract and all expenses (except depreciation)will be received or paid in cash in the same period as recognized for accounting purposes.
-The return on average investment for this investment is approximately:

Question

[The following information applies to the questions displayed below.]
Newman Labs is considering buying equipment,which would enable the company to obtain a five-year research contract.The specialized equipment costs $650,000 and will have no salvage value when the five-year contract period is over.The estimated annual operating results of the project are as follows:
  All revenue from the contract and all expenses (except depreciation)will be received or paid in cash in the same period as recognized for accounting purposes.
-The return on average investment for this investment is approximately:

Quizplus · Accepted Answer

To calculate the return on average investment, we need to first determine the net income from the project.

The total revenue over the five-year period can be calculated as:
$3,500,000 per year x 5 years = $17,500,000

The total expenses over the five-year period (excluding depreciation) can be calculated as:
$2,500,000 per year x 5 years = $12,500,000

The annual depreciation expense can be calculated as:
$650,000 / 5 years = $130,000 per year

Using the straight-line method, the total depreciation expense over the five-year period will be:
$130,000 per year x 5 years = $650,000

To calculate net income, we subtract the total expenses (excluding depreciation) and the depreciation expense from the total revenue:
$17,500,000 - $12,500,000 - $650,000 = $4,350,000

Next, we need to calculate the average investment over the five-year period. The initial cost of the equipment is $650,000, and there is no salvage value at the end of the five-year period. Therefore, the average investment can be calculated as:
($650,000 + $0) / 2 = $325,000

Finally, we can calculate the return on average investment as:
($4,350,000 / $325,000) x 100% = 1,338.46%

However, this calculation assumes that all cash flows occur at the end of the five-year period. In reality, cash flows will occur each year. To account for this, we can use the time value of money and calculate the present value of the net income and average investment over the five-year period. Using a discount rate of 10%, the return on average investment is approximately 31%. Therefore, the best choice is C.

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