Textbook Problem

Accounting Rate of Return

Each of the following scenarios is independent. Assume that all cash flows are after-tax cash flows.

Cobre Company is considering the purchase of new equipment that will speed up the process for extracting copper. The equipment will cost $3,600,000 and have a life of 5 years with no expected salvage value. The expected cash flows associated with the project are as follows:

Emily Hansen is considering investing in one of the following two projects. Either project will require an investment of $75,000. The expected cash revenues minus cash expenses for the two projects follow. Assume each project is depreciable.

Suppose that a project has an ARR of 30% (based on initial investment) and that the average net income of the project is $120,000.

Suppose that a project has an ARR of 50% and that the investment is $150,000.

Required:

Compute the ARR on the new equipment that Cobre Company is considering.

CONCEPTUAL CONNECTION Which project should Emily Hansen choose based on the ARR? Notice that the payback period is the same for both investments (thus equally preferred). Unlike the payback period, explain why ARR correctly signals that one project should be preferred over the other.

How much did the company in Scenario c invest in the project?

What is the average net income earned by the project in Scenario d?