Question

XYZ Company is considering building a new warehouse in Yas. It will require an initial capital investment of $ 10 000. The investment will have a three-year life, and will be depreciated on a straight line basis to a zero book value over the next three years.

The new project will generate the following net income over each of the next three years for the company:

  

Year	Expected Net Income ($)
1	500
2	1,000
3	1,500

1. Calculate the Accounting Rate of Return (ARR) for this investment.
2. Should the Company accept the project if the required rate of return was 15%? Explain.

3. Considering the advantages of the Accounting Rate of Return Method, evaluate the use of ARR method on the company investment decision.

Answer 1

Solution:

a)Calcculation of ARR

ARR=Average Net Income/Initial Investment

Average Net Income=$500+$1000+$1500/3

=$3000/3=$1000

ARR=$1000/$10,000

=0.10 or 10%

b)Since the ARR(10%) is less than the required rate of return of 15%,hence company should not accept the project.

c)The ARR compares income to the initial investment rather than those to cash flows,thus incremental revenues,cost savings and incremental expenes associated with the investment are reviewed and provide a more complete picture than payback which uses cash flows.With the help of ARR,company can evaluate its investment decision on more rationale basis.