Question

An investment that requires initial cash outlay of $100,000 has a useful life of 3 years. In each of these years the before-tax cash flow is $40,000. If the tax rate is 34% and straight-line depreciation is used, the average accounting return is:

a. 40.00%

b. 26.40%

c. 13.34%

d. 8.80%

Answer 1

Answer is 8.80%

Initial Outlay = $100,000
Useful Life = 3 years

Annual Depreciation = Initial Outlay / Useful Life
Annual Depreciation = $100,000 / 3
Annual Depreciation = $33,333.333

Average Investment = (Initial Outlay + Residual Value) / 2
Average Investment = ($100,000 + $0) / 2
Average Investment = $50,000

Before-tax Cash Flow = Before-tax Income + Depreciation
$40,000 = Before-tax Income + $33,333.333
Before-tax Income = $6,666.667

After-tax Income = Before-tax Income * (1 - Tax Rate)
After-tax Income = $6,666.67 * (1 - 0.34)
After-tax Income = $4,400

Average Accounting Return = After-tax Income / Average Investment
Average Accounting Return = $4,400 / $50,000
Average Accounting Return = 8.80%