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Hi Sir,
Really stuck on this question
Lincoln Tea, not surprisingly, makes tea. The company is contemplating purchasing equipment for an additional processing line. The additional processing line would increase revenues by €90,000 per year. Incremental cash operating expense would be €40,000 per year. The equipment would cost €180,000 and have a nine year life. No salvage value is projected.
What is the average accounting rate of return?The answer is 33%
My Method has been 180/9=20
Cashflow=90-40=50
50-20/180=16.6%Can anyone please explain what I am doing wrong please
Thanks
Two things:
Firstly, the accounting rate of return is an accounting measure and we use the profit (not the cash flow). The depreciation is 180,000/9 = 20,000 per year, and therefore the profit is 50,000 – 20,000 = 30,000 per year.
Secondly, since the book value of the equipment is 180,000 at the start and is 0 at the end, the average investment is 180,000 / 2 = 90,000.
Therefore the ARR = 30,000/90,000 = 33%
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