WeCare Clinic is planning on investing in some new echocardiogram equipment that will require an initial outlay of $170,000. 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: $68,000, $68,000, $85,000, $85,000, and $102,000.
Required:
Calculate the annual net income for each of the five years.
Calculate the accounting rate of return.
What if a second competing revenue-producing investment has the same initial outlay and salvage value but the following cash flows (in chronological sequence): $102,000, $102,000, $102,000, $68,000, and $17,000? Using the accounting rate of return metric, which project should be selected: the first or the second? Which project is really the better of the two?
Answer | ||
1) Calculate net income : | ||
Net income | ||
Year 1 | 68000-34000 = 34000 | |
Year 2 | 68000-34000 = 34000 | |
Year 3 | 85000-34000 = 51000 | |
Year 4 | 85000-34000 = 51000 | |
Year 5 | 102000-34000 = 68000 | |
2) Accounting rate of return = Average net income*100/Average investment | ||
Average net income = 238000/5 = 47600 | ||
Average investment = 170000/2 = 85000 | ||
Accounting rate of return = 47600*100/85000= 56% | ||
3) Calculate net income : | ||
Net income | ||
Year 1 | 102000-34000 = 68000 | |
Year 2 | 102000-34000 = 68000 | |
Year 3 | 102000-34000 = 68000 | |
Year 4 | 68000-34000 = 34000 | |
Year 5 | 17000-34000 = -17000 | |
Accounting rate of return = Average net income*100/Average investment | ||
Average net income = 210000/5 = 42000 | ||
Average investment = 170000/2 = 85000 | ||
Accounting rate of return = 42000*100/85000= 49.41% |
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