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John Moffat.
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Convery
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Hi,
In the mock exam there is the following question,Calculate the Accounting Rate of Return for the project with;
Initial Cost – $300,000
Expected Life – 5 years
Estimated Scrap Value – $20,000
Additional revenue from the project per year – $120,000
Incremental costs of the project – $30,000 per year
Cost of Capital – 10%The answer is saying 21% but I don’t understand how they’re getting to that figure.
Thanks!
John Moffat
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The total profit before depreciation over the 5 years is 5 x (120,000 – 30,000) = 450,000.
The total depreciation over the 5 years is 300,000 – 20,000 = 280,000.
Therefore the total accounting profit is 450,000 – 280,000 = 170,000, and the average annual profit is 170,000/5 = 34,000 per year.The average amount invested is (300,000 + 20,000) / 2 = 160,000.
Therefore the ARR is 34,000 / 160,000 = 21.25%
Convery
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Thank you for this,
but why is the average amount invested $160,000? I don’t understand why $20,000 is considered an investment?John Moffat
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At the start of the investment there is $300,000 invested and this is what will appear on the Statement of Financial Position (Balance Sheet). This will be depreciated over the life of the project and so the value on the Statement will fall each year. At the end of the investment it will appear as having a value of only $20,000. So the average over the 5 year period will be half way between the two at $160,000.
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