# Exercise-9 (Computation of accounting rate of return – cost reduction project)

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%

Required:

1. Compute accounting rate of return (or simple rate of return) of the equipment.
2. Is this investment desirable?

## Solution:

(1) Computation of accounting rate of return (simple rate of return):

Accounting/simple rate of return = Net cost savings/Initial investment

= \$13,125/\$90,000

= 14.58%

*Annual cost savings – Depreciation:
= \$18,750 – \$5,625
= \$13,125

(2) Conclusion:

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.

A D V E R T I S E M E N T