Question

Ennis Ltd is considering the purchase of a machine to produce a new product. The machine will cost the business £450,000 and has an expected life of five years. Annual operating profits from the machine are expected to be as follows

The new machine will be depreciated using the straight-line method and the estimated disposal value at the end of its useful life is £70,000.
The business has a target accounting rate of return of 25% for new investment projects.
a)   Calculate the accounting rate of return for the new machine.
b) Should the machine be purchased?

      Operating profits
       £
Year 1      58,000
Year 2      82,000
Year 3      69,000
Year 4      38,000
Year 5      28,000

Answer 1

a) Accounting rate of return = Average Net profits / Average New investment

= -21000/ 225000

= - 9.33%

b) No machine should not be purchased as the accounting rate of return is -9.33% against business target rate of return of 25%

Notes :-

Average annual cash inflow = £ (58000 + 82000 + 69000 + 38000 + 28000) / 5

= £ 55000

Annual depreciation expense = £ (450000 - 70000) / 5

= £ 76000

Average net profits = Average annual cash inflow - Annual Depreciation

= £ (55000 - 76000)

= - £ 21000

Average new investment = £ (450000 + 0) / 2

= £ 225000