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

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