Question

Midwest Fabricators Inc. is considering an investment in equipment that will replace direct labor. The equipment has a cost of $111,000 with a $10,000 residual value and a ten-year life. The equipment will replace one employee who has an average wage of $19,080 per year. In addition, the equipment will have operating and energy costs of $5,350 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

Computation of average rate of return on the equipment :

Average annual net savings = Annual savings - Annual Estimated Cash cost

Annual savings = Savings in average wages = 19080

Annual depreciation = (Cost of equipment - Scrap value)/Useful life

= (111000 - 10000)/10 = 10100

Annual estimated cash costs = operating and energy costs = 5350

Average annual net savings = 19080 - 5350 - 10100 + 10100 = 13730

Average investment = (Opening investment + Scrap value) / 2

= (111000 + 10000) / 2 = 60500

Average Rate of Return = Average annual net savings / Average Investment

=13730 / 60500 = 22.69%

Note: Depreciation is non cash expenditure and it will not have any effect on cash savings per year.