Question

Accounting Rate of Return

WeCare Clinic is planning on investing in some new echocardiogram equipment that will require an initial outlay of $155,000. The system has an expected life of five years and no expected salvage value. The investment is expected to produce the following net cash flows over its life: $80,000, $70,000, $84,000, $83,000, and $92,000.

Required:

1. Calculate the annual net income for each of the five years.

	Net Income
Year 1	$ __________
Year 2	$___________
Year 3	$__________
Year 4	$__________
Year 5	$____________

2. Calculate the accounting rate of return. Enter your answer as a whole percentage value (for example, 16% should be entered as "16").
_____________%

3. What if a second competing revenue-producing investment has the same initial outlay and salvage value but the following cash flows (in chronological sequence): $92,000, $92,000, $92,000, $80,000, and $26,500? Calculate its accounting rate of return. Enter your answer as a whole percentage value (for example, 16% should be entered as "16").
_____________%

Answer 1

1) Calculate net income :

	Net income
Year 1	80000-31000 = 49000
Year 2	70000-31000 = 39000
Year 3	84000-31000 = 53000
Year 4	83000-31000 = 52000
Year 5	92000-31000 = 61000

2) Accounting rate of return = Average net income*100/Average investment

Average net income = 254000/5 = 50800

Average investment = 155000/2 = 77500

Accounting rate of return = 50800*100/77500= 66%

3) Calculate net income :

	Net income
Year 1	92000-31000 = 61000
Year 2	92000-31000 = 61000
Year 3	92000-31000 = 61000
Year 4	80000-31000 = 49000
Year 5	26500-31000 = -4500

Accounting rate of return = Average net income*100/Average investment

Average net income = 227500/5 = 45500

Average investment = 155000/2 = 77500

Accounting rate of return = 45500*100/77500= 59%