Rahat Manufacturing company uses accounting rate of return to analyze investment in plant assets. The company wants to reduce its total annual cost by purchasing a new equipment to be installed in the factory. The relevant information about investment in new equipment is presented to you:
- Amount required to purchase the equipment: $90,000
- Expected annual cost savings: $18,750
- Useful life of the equipment: 16 years
- Straight line depreciation per year: $5,625
- Residual value of the equipment at the end of 16-year period: $0
- Required rate of return: 16%
- Compute accounting rate of return (or simple rate of return) of the equipment.
- Is this investment desirable?
(1) Computation of accounting rate of return (simple rate of return):
Accounting/simple rate of return = Net cost savings/Initial investment
*Annual cost savings – Depreciation:
= $18,750 – $5,625
The accounting rate of return of the equipment is 14.58% which is less than the desired rate of return of the management. If only accounting rate of return is considered, the investment is not desirable.