Question

The Even Cut Co. is considering opening a new plant to produce lawn mowers. The initial cost of the project is $6 million. This cost will be depreciated straight-line to a zero book value over the 15-year life of the project. The net income of the project is expected to be $137,000 a year for the first four years and $538,000 for years 5 through 15, respectively. What is the average accounting return on this project? why average net investment is 6000000/2 why needed to divided by 2?

Answer 1

Initial cost = $6 million.

Useful Life = 15 years

Salvage Value = 0

Net income (year 1 to Year 4) = $137,000 each year

Net Income (year 5 to year 15) = $538,000

Average Accounting Profit = (137000*4+538000*11)/15 = $431,066.67

Average Investment is the average of book value at the beginning and book value at the end of the term.

i.e. Average Investment = (Initial Cost + Salvage Value)/2 = (6,000,000+0)/2 = $3,000,000.00

Since, salvage value is zero, it is coming as Initial investment/2 i.e. 6000000/2.

Average Accounting return = Average accounting profit/Average Investment

Average Accounting return = 431066.67/3000000 = .1437 or 14.37%

Hence, average accounting return = 14.37%