Accounting Rate of Return
WeCare Clinic is planning on investing in some new echocardiogram equipment that will require an initial outlay of $145,000. The system has an expected life of five years and no expected salvage value. The investment is expected to produce the following net cash flows over its life: $88,000, $76,000, $84,000, $83,000, and $95,000.
Required:
1. Calculate the annual net income for each of the five years.
Net Income | |
Year 1 | $ |
Year 2 | $ |
Year 3 | $ |
Year 4 | $ |
Year 5 | $ |
2. Calculate the accounting rate of return.
Enter your answer as a whole percentage value (for example, 16%
should be entered as "16").
%
3. What if a second competing
revenue-producing investment has the same initial outlay and
salvage value but the following cash flows (in chronological
sequence): $95,000, $95,000, $95,000, $88,000, and $26,500?
Calculate its accounting rate of return. Enter your answer as a
whole percentage value (for example, 16% should be entered as
"16").
%
Solution 1:
Annual depreciation = $145,000 / 5 = $29,000
Computation of annual net income | |||
Cash Inflows | Depreciation | Net Income | |
Year 1 | $88,000.00 | $29,000.00 | $59,000.00 |
Year 2 | $76,000.00 | $29,000.00 | $47,000.00 |
Year 3 | $84,000.00 | $29,000.00 | $55,000.00 |
Year 4 | $83,000.00 | $29,000.00 | $54,000.00 |
Year 5 | $95,000.00 | $29,000.00 | $66,000.00 |
Solution 2:
Average annual income = ($59,000 + $47,000 + $55,000 + $54,000 + $66,000) / 5 = $56,200
Accounting rate of return = Average annual income / Initial investment = $56,200 / $145,000 = 39%
Solution 3:
Computation of annual net income | |||
Cash Inflows | Depreciation | Net Income | |
Year 1 | $95,000.00 | $29,000.00 | $66,000.00 |
Year 2 | $95,000.00 | $29,000.00 | $66,000.00 |
Year 3 | $95,000.00 | $29,000.00 | $66,000.00 |
Year 4 | $88,000.00 | $29,000.00 | $59,000.00 |
Year 5 | $26,500.00 | $29,000.00 | -$2,500.00 |
Average annual income = ($66,000 + $66,000 + $66,000 + $59,000 - $2,500) / 5 = $50,900
Accounting rate of return = Average annual income / Initial investment = $50,900 / $145,000 = 35%
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