Question

Average Rate of Return—Cost Savings

Midwest Fabricators Inc. is considering an investment in equipment that will replace direct labor. The equipment has a cost of $90,000 with a $8,000 residual value and a five-year life. The equipment will replace one employee who has an average wage of $31,460 per year. In addition, the equipment will have operating and energy costs of $8,690 per year.

Determine the average rate of return on the equipment, giving effect to straight-line depreciation on the investment. If required, round to the nearest whole percent.

Answer 1

ARR is 7% or 13%

As there is two formula to calculate ARR ie from Initial Investment and Average investment .

Average rate of Return is the return on Net income to the average investment or intial investment . It is return generated from the capital investment.

Depreciation on Investment under Straight-line

Depreciation =(Cost of Equipment - Salvage value )/ Useful life of Asset

=(90000-8000)/5

=82000/5

=16400

Net Increase in profit /Income from saving in labour cost .

	Net Income per annum
Saving in Labour cost	$31460
less : Annual incremental cost on Equipment	$(8690)
Less :Annual Depreciation	$(16400)
Net Saving /Income	$6370

Average Annual Rate of Return =Net income /Intial Investment or Average investment

=$6370/90000

=7%

Or Average Investment = (Cost of Equipment + Salvage)/2

=(90000+8000)/2

=49000

Average Annual Return =6370/49000 = 13%