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.

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